PA R T
1
INTRODUCTION
TO MANAGERIAL
FINANCE
CHAPTERS IN THIS PART
1
The Role and Environment of Managerial Finance
2
Financial Statements and Analysis
3
Cash Flow and Financial Planning
Integrative Case I: Track Software, Inc.
1
CHAPTER
1
THE ROLE
AND ENVIRONMENT
OF MANAGERIAL FINANCE
L E A R N I N G
LG1
LG2
LG3
Define finance, the major areas of finance
and the career opportunities available in this
field, and the legal forms of business
organization.
Describe the managerial finance function
and its relationship to economics and
accounting.
Identify the primary activities of the financial
manager within the firm.
LG4
LG5
LG6
G O A L S
Explain why wealth maximization, rather than
profit maximization, is the firm’s goal and how the
agency issue is related to it.
Understand the relationship between financial
institutions and markets, and the role and operations of the money and capital markets.
Discuss the fundamentals of business taxation of
ordinary income and capital gains, and explain
the treatment of tax losses.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand the relationships
between the firm’s accounting and finance functions; how the
financial statements you prepare will be used for making
investment and financing decisions; ethical behavior by those
responsible for a firm’s funds; what agency costs are and why
the firm must bear them; and how to calculate the tax effects of
proposed transactions.
Information systems: You need to understand the organization
of the firm; why finance personnel require both historical and
projected data to support investment and financing decisions;
and what data are necessary for determining the firm’s tax
liability.
Management: You need to understand the legal forms of business organization; the tasks that will be performed by finance
2
personnel; the goal of the firm; the issue of management compensation; the role of ethics in the firm; the agency problem;
and the firm’s relationship to various financial institutions and
markets.
Marketing: You need to understand how the activities you pursue will be affected by the finance function, such as the firm’s
cash and credit management policies; the role of ethics in promoting a sound corporate image; and the role the financial markets play in the firm’s ability to raise capital for new projects.
Operations: You need to understand the organization of the
firm and of the finance function in particular; why maximizing
profit is not the main goal of the firm; the role of financial institutions and markets in providing funds for the firm’s production
capacity; and the agency problem and the role of ethics.
STARBUCKS
KEEPING STARBUCKS
HOT AND STRONG
ometimes it seems that there’s a Starbucks
on every corner—and now in supermarkets and hospitals, too. The company that revolutionized the way we think about coffee now
has over 4,800 retail locations worldwide and
15 million customers lining up for lattes and
other concoctions each week.
The chain’s success is tied to somewhat
unusual business strategies. Its mission statement emphasizes creating a better work environment for employees first, then satisfying customers and promoting good corporate citizenship
within its communities. For example, Starbucks was one of the first companies to offer part-time
employees health benefits and equity (ownership). The goal is to create an experience that builds
trust with the customer. Profits are among the last of the company’s guiding principles.
Starbucks’ bond with employees and customers has translated into sales and earnings as
strong as its coffee. Annual sales growth from 1997 to 2000 ranged from 28 to almost 40 percent,
and annual growth in earnings per share ranged from about 12 to 81 percent. A share of Starbucks’ stock purchased in November 1996 increased in value by 17 percent over the five years
ended November 2001. That compares favorably with the 15 percent gain realized by its industry
peers and the 7 percent gain for companies in the Standard & Poor’s 500 Index.
Despite the U.S. economic slowdown in 2001, the company expects to keep its growth perking over the next five years. Although some fear that Starbucks has saturated the domestic market, same-store sales keep rising as the company introduces new products. Starbucks has even
become quite successful in unexpected markets, such as Japan.
Accomplishing its business objectives while building shareholder value requires sound
financial management—raising funds to open new stores and build more roasting plants, deciding when and where to put them, managing cash collections, reducing purchasing costs, and
dealing with fluctuations in the value of foreign currency and with other risks as it buys coffee
beans and expands overseas. To finance its growth, Starbucks went public (sold common stock)
in 1992, and its stock trades on the Nasdaq national market. Its next securities offering was the
sale of convertible bonds, debt securities that could be converted into common stock at a specified price. Those bonds were successfully converted into common stock by 1996, and today the
company has almost no long-term debt.
Like Starbucks, every company must deal with many different issues to keep its financial
condition solid. Chapter 1 introduces managerial finance and its key role in helping an organization meet its financial and business objectives.
S
3
4
PART 1
Introduction to Managerial Finance
LG1
1.1 Finance and Business
The field of finance is broad and dynamic. It directly affects the lives of every person and every organization. There are many areas and career opportunities in the
field of finance. Basic principles of finance, such as those you will learn in this
textbook, can be universally applied in business organizations of different types.
What Is Finance?
finance
The art and science of managing
money.
Finance can be defined as the art and science of managing money. Virtually all
individuals and organizations earn or raise money and spend or invest money.
Finance is concerned with the process, institutions, markets, and instruments
involved in the transfer of money among individuals, businesses, and governments. Most adults will benefit from an understanding of finance, which will
enable them to make better personal financial decisions. Those who work in
financial jobs will benefit by being able to interface effectively with the firm’s
financial personnel, processes, and procedures.
Major Areas and Opportunities in Finance
The major areas of finance can be summarized by reviewing the career opportunities in finance. These opportunities can, for convenience, be divided into two
broad parts: financial services and managerial finance.
Financial Services
financial services
The part of finance concerned
with the design and delivery of
advice and financial products to
individuals, business, and
WW
government.
W
Financial services is the area of finance concerned with the design and delivery of
advice and financial products to individuals, business, and government. It
involves a variety of interesting career opportunities within the areas of banking
and related institutions, personal financial planning, investments, real estate, and
insurance. Career opportunities available in each of these areas are described at
this textbook’s Web site at www.aw.com/gitman.
Managerial Finance
managerial finance
Concerns the duties of the financial manager in the business
firm.
financial manager
Actively manages the financial
affairs of any type of business,
whether financial or nonfinancial, private or public, large or
small, profit-seeking or not-forprofit.
Managerial finance is concerned with the duties of the financial manager in the
business firm. Financial managers actively manage the financial affairs of any
type of businesses—financial and nonfinancial, private and public, large and
small, profit-seeking and not-for-profit. They perform such varied financial tasks
as planning, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations. In recent years, the changing economic and regulatory environments have increased the importance and
complexity of the financial manager’s duties. As a result, many top executives
have come from the finance area.
Another important recent trend has been the globalization of business activity. U.S. corporations have dramatically increased their sales, purchases, investments, and fund raising in other countries, and foreign corporations have likewise
CHAPTER 1
The Role and Environment of Managerial Finance
5
increased these activities in the United States. These changes have created a need
for financial managers who can help a firm to manage cash flows in different currencies and protect against the risks that naturally arise from international transactions. Although these changes make the managerial finance function more complex, they can also lead to a more rewarding and fulfilling career.
Legal Forms of Business Organization
The three most common legal forms of business organization are the sole proprietorship, the partnership, and the corporation. Other specialized forms of business
organization also exist. Sole proprietorships are the most numerous. However,
corporations are overwhelmingly dominant with respect to receipts and net profits. Corporations are given primary emphasis in this textbook.
Sole Proprietorships
sole proprietorship
A business owned by one person
and operated for his or her own
profit.
unlimited liability
The condition of a sole proprietorship (or general partnership)
allowing the owner’s total
wealth to be taken to satisfy
creditors.
A sole proprietorship is a business owned by one person who operates it for his
or her own profit. About 75 percent of all business firms are sole proprietorships.
The typical sole proprietorship is a small business, such as a bike shop, personal
trainer, or plumber. The majority of sole proprietorships are found in the wholesale, retail, service, and construction industries.
Typically, the proprietor, along with a few employees, operates the proprietorship. He or she normally raises capital from personal resources or by borrowing and is responsible for all business decisions. The sole proprietor has unlimited
liability; his or her total wealth, not merely the amount originally invested, can be
taken to satisfy creditors. The key strengths and weaknesses of sole proprietorships are summarized in Table 1.1.
Partnerships
partnership
A business owned by two or
more people and operated for
profit.
articles of partnership
The written contract used to
formally establish a business
partnership.
corporation
An artificial being created by
law (often called a “legal
entity”).
Hint For many small
corporations, as well as small
proprietorships and partnerships, there is no access to
financial markets. In addition,
whenever the owners take out a
loan, they usually must
personally cosign the loan.
A partnership consists of two or more owners doing business together for profit.
Partnerships account for about 10 percent of all businesses, and they are typically
larger than sole proprietorships. Finance, insurance, and real estate firms are the
most common types of partnership. Public accounting and stock brokerage partnerships often have large numbers of partners.
Most partnerships are established by a written contract known as articles of
partnership. In a general (or regular) partnership, all partners have unlimited liability, and each partner is legally liable for all of the debts of the partnership.
Strengths and weaknesses of partnerships are summarized in Table 1.1.
Corporations
A corporation is an artificial being created by law. Often called a “legal entity,” a
corporation has the powers of an individual in that it can sue and be sued, make
and be party to contracts, and acquire property in its own name. Although only
about 15 percent of all businesses are incorporated, the corporation is the dominant form of business organization in terms of receipts and profits. It accounts
for nearly 90 percent of business receipts and 80 percent of net profits. Although
6
PART 1
TABLE 1.1
Introduction to Managerial Finance
Strengths and Weaknesses of the Common Legal Forms
of Business Organization
Sole proprietorship
Partnership
Corporation
Strengths
• Owner receives all profits (and
sustains all losses)
• Low organizational costs
• Income included and taxed on
proprietor’s personal tax return
• Independence
• Secrecy
• Ease of dissolution
• Can raise more funds than sole
proprietorships
• Borrowing power enhanced
by more owners
• More available brain power and
managerial skill
• Income included and taxed
on partner’s tax return
• Owners have limited liability,
which guarantees that they cannot lose more than they invested
• Can achieve large size via sale
of stock
• Ownership (stock) is readily
transferable
• Long life of firm
• Can hire professional managers
• Has better access to financing
• Receives certain tax advantages
Weaknesses
• Owner has unlimited liability—
total wealth can be taken to
satisfy debts
• Limited fund-raising power tends
to inhibit growth
• Proprietor must be jack-of-alltrades
• Difficult to give employees longrun career opportunities
• Lacks continuity when proprietor
dies
• Owners have unlimited liability
and may have to cover debts of
other partners
• Partnership is dissolved when a
partner dies
• Difficult to liquidate or transfer
partnership
• Taxes generally higher, because
corporate income is taxed, and
dividends paid to owners are also
taxed
• More expensive to organize than
other business forms
• Subject to greater government
regulation
• Lacks secrecy, because stockholders must receive financial
reports
stockholders
The owners of a corporation,
whose ownership, or equity, is
evidenced by either common
stock or preferred stock.
common stock
The purest and most basic form
of corporate ownership.
dividends
Periodic distributions of earnings
to the stockholders of a firm.
board of directors
Group elected by the firm’s
stockholders and having ultimate
authority to guide corporate
affairs and make general policy.
corporations are involved in all types of businesses, manufacturing corporations
account for the largest portion of corporate business receipts and net profits. The
key strengths and weaknesses of large corporations are summarized in Table 1.1.
The owners of a corporation are its stockholders, whose ownership, or
equity, is evidenced by either common stock or preferred stock.1 These forms of
ownership are defined and discussed in Chapter 7; at this point suffice it to say
that common stock is the purest and most basic form of corporate ownership.
Stockholders expect to earn a return by receiving dividends—periodic distributions of earnings—or by realizing gains through increases in share price.
As noted in the upper portion of Figure 1.1, the stockholders vote periodically
to elect the members of the board of directors and to amend the firm’s corporate
charter. The board of directors has the ultimate authority in guiding corporate
affairs and in making general policy. The directors include key corporate personnel as well as outside individuals who typically are successful businesspeople and
executives of other major organizations. Outside directors for major corporations
are generally paid an annual fee of $10,000 to $20,000 or more. Also, they are
1. Some corporations do not have stockholders but rather have “members” who often have rights similar to those of
stockholders—that is, they are entitled to vote and receive dividends. Examples include mutual savings banks, credit
unions, mutual insurance companies, and a whole host of charitable organizations.
CHAPTER 1
FIGURE 1.1
The Role and Environment of Managerial Finance
7
Corporate Organization
The general organization of a corporation and the finance function (which is shown in yellow)
Stockholders
elect
Board of Directors
Owners
hires
President
(CEO)
Vice President
Human
Resources
Vice President
Manufacturing
Vice President
Finance
(CFO)
Managers
Vice President
Marketing
Treasurer
Capital
Expenditure
Manager
Financial
Planning and
Fund-Raising
Manager
Credit
Manager
Cash
Manager
president or chief
executive officer (CEO)
Corporate official responsible for
managing the firm’s day-to-day
operations and carrying out the
policies established by the board
of directors.
Vice President
Information
Resources
Controller
Foreign
Exchange
Manager
Pension Fund
Manager
Tax
Manager
Corporate
Accounting
Manager
Cost
Accounting
Manager
Financial
Accounting
Manager
frequently granted options to buy a specified number of shares of the firm’s stock
at a stated—and often attractive—price.
The president or chief executive officer (CEO) is responsible for managing
day-to-day operations and carrying out the policies established by the board. The
CEO is required to report periodically to the firm’s directors.
It is important to note the division between owners and managers in a large
corporation, as shown by the dashed horizontal line in Figure 1.1. This separation and some of the issues surrounding it will be addressed in the discussion of
the agency issue later in this chapter.
8
PART 1
Introduction to Managerial Finance
Other Limited Liability Organizations
limited partnership (LP)
S corporation (S corp)
limited liability corporation (LLC)
limited liability partnership (LLP)
See Table 1.2.
A number of other organizational forms provide owners with limited liability.
The most popular are limited partnerships (LPs), S corporations (S corps), limited
liability corporations (LLCs), and limited liability partnerships (LLPs). Each represents a specialized form or blending of the characteristics of the organizational
forms described before. What they have in common is that their owners enjoy
limited liability, and they typically have fewer than 100 owners. Each of these
limited liability organizations is briefly described in Table 1.2.
The Study of Managerial Finance
An understanding of the theories, concepts, techniques, and practices presented
throughout this text will fully acquaint you with the financial manager’s activities
and decisions. Because most business decisions are measured in financial terms,
the financial manager plays a key role in the operation of the firm. People in all
areas of responsibility—accounting, information systems, management, marketing, operations, and so forth—need a basic understanding of the managerial
finance function.
All managers in the firm, regardless of their job descriptions, work with financial personnel to justify laborpower requirements, negotiate operating budgets,
deal with financial performance appraisals, and sell proposals at least partly on the
basis of their financial merits. Clearly, those managers who understand the finan-
TABLE 1.2
Other Limited Liability Organizations
Organization
Description
Limited partnership (LP)
A partnership in which one or more partners have limited liability as long as at least one
partner (the general partner) has unlimited liability. The limited partners cannot take an
active role in the firm’s management; they are passive investors.
S corporation (S corp)
A tax-reporting entity that (under Subchapter S of the Internal Revenue Code)
allows certain corporations with 75 or fewer stockholders to choose to be taxed as
partnerships. Its stockholders receive the organizational benefits of a corporation and
the tax advantages of a partnership. But S corps lose certain tax advantages related to
pension plans.
Limited liability corporation (LLC)
Permitted in most states, the LLC gives its owners, like those of S corps, limited liability
and taxation as a partnership. But unlike an S corp, the LLC can own more than 80%
of another corporation, and corporations, partnerships, or non-U.S. residents can own
LLC shares. LLCs work well for corporate joint ventures or projects developed through
a subsidiary.
Limited liability partnership (LLP)a
A partnership permitted in many states; governing statutes vary by state. All LLP
partners have limited liability. They are liable for their own acts of malpractice, not for
those of other partners. The LLP is taxed as a partnership. LLPs are frequently used by
legal and accounting professionals.
aIn recent years this organizational form has begun to replace professional corporations or associations—corporations formed by groups of
professionals such as attorneys and accountants that provide limited liability except for that related to malpractice—because of the tax advantages
it offers.
CHAPTER 1
TABLE 1.3
The Role and Environment of Managerial Finance
9
Career Opportunities in Managerial Finance
Position
Description
Financial analyst
Primarily prepares the firm’s financial plans and budgets. Other duties include financial forecasting, performing financial comparisons, and working closely with accounting.
Capital expenditures manager
Evaluates and recommends proposed asset investments. May be involved in the financial
aspects of implementing approved investments.
Project finance manager
In large firms, arranges financing for approved asset investments. Coordinates consultants,
investment bankers, and legal counsel.
Cash manager
Maintains and controls the firm’s daily cash balances. Frequently manages the firm’s cash collection and disbursement activities and short-term investments; coordinates short-term borrowing and banking relationships.
Credit analyst/manager
Administers the firm’s credit policy by evaluating credit applications, extending credit, and
monitoring and collecting accounts receivable.
Pension fund manager
In large companies, oversees or manages the assets and liabilities of the employees’ pension
fund.
Foreign exchange manager
Manages specific foreign operations and the firm’s exposure to fluctuations in exchange rates.
cial decision-making process will be better able to address financial concerns and
will therefore more often get the resources they need to attain their own goals. The
“Across the Disciplines” element that appears on each chapter-opening page
should help you understand some of the many interactions between managerial
finance and other business careers.
As you study this text, you will learn about the career opportunities in managerial finance, which are briefly described in Table 1.3. Although this text focuses
on publicly held profit-seeking firms, the principles presented here are equally
applicable to private and not-for-profit organizations. The decision-making principles developed in this text can also be applied to personal financial decisions. I
hope that this first exposure to the exciting field of finance will provide the foundation and initiative for further study and possibly even a future career.
Review Questions
1–1
1–2
1–3
1–4
1–5
1–6
What is finance? Explain how this field affects the lives of everyone and
every organization.
What is the financial services area of finance? Describe the field of managerial finance.
Which legal form of business organization is most common? Which form
is dominant in terms of business receipts and net profits?
Describe the roles and the basic relationship among the major parties in a
corporation—stockholders, board of directors, and president. How are
corporate owners compensated?
Briefly name and describe some organizational forms other than corporations that provide owners with limited liability.
Why is the study of managerial finance important regardless of the specific
area of responsibility one has within the business firm?
10
PART 1
LG2
Introduction to Managerial Finance
LG3
1.2 The Managerial Finance Function
People in all areas of responsibility within the firm must interact with finance
personnel and procedures to get their jobs done. For financial personnel to
make useful forecasts and decisions, they must be willing and able to talk to
individuals in other areas of the firm. The managerial finance function can be
broadly described by considering its role within the organization, its relationship to economics and accounting, and the primary activities of the financial
manager.
treasurer
The firm’s chief financial manager, who is responsible for the
firm’s financial activities, such
as financial planning and fund
raising, making capital expenditure decisions, and managing
cash, credit, the pension fund,
and foreign exchange.
controller
The firm’s chief accountant, who
is responsible for the firm’s
accounting activities, such as
corporate accounting, tax
management, financial accounting, and cost accounting.
Hint A controller is
sometimes referred to as a
comptroller. Not-for-profit and
governmental organizations
frequently use the title of
comptroller.
foreign exchange manager
The manager responsible for
monitoring and managing the
firm’s exposure to loss from
currency fluctuations.
Organization of the Finance Function
The size and importance of the managerial finance function depend on the size of
the firm. In small firms, the finance function is generally performed by the
accounting department. As a firm grows, the finance function typically evolves
into a separate department linked directly to the company president or CEO
through the chief financial officer (CFO). The lower portion of the organizational
chart in Figure 1.1 (on page 7) shows the structure of the finance function in a
typical medium-to-large-size firm.
Reporting to the CFO are the treasurer and the controller. The treasurer (the
chief financial manager) is commonly responsible for handling financial activities, such as financial planning and fund raising, making capital expenditure decisions, managing cash, managing credit activities, managing the pension fund, and
managing foreign exchange. The controller (the chief accountant) typically handles the accounting activities, such as corporate accounting, tax management,
financial accounting, and cost accounting. The treasurer’s focus tends to be more
external, the controller’s focus more internal. The activities of the treasurer, or
financial manager, are the primary concern of this text.
If international sales or purchases are important to a firm, it may well
employ one or more finance professionals whose job is to monitor and manage
the firm’s exposure to loss from currency fluctuations. A trained financial manager can “hedge,” or protect against such a loss, at reasonable cost by using a
variety of financial instruments. These foreign exchange managers typically
report to the firm’s treasurer.
Relationship to Economics
marginal analysis
Economic principle that states
that financial decisions should
be made and actions taken only
when the added benefits exceed
the added costs.
The field of finance is closely related to economics. Financial managers must
understand the economic framework and be alert to the consequences of varying
levels of economic activity and changes in economic policy. They must also be
able to use economic theories as guidelines for efficient business operation.
Examples include supply-and-demand analysis, profit-maximizing strategies, and
price theory. The primary economic principle used in managerial finance is
marginal analysis, the principle that financial decisions should be made and
actions taken only when the added benefits exceed the added costs. Nearly all
financial decisions ultimately come down to an assessment of their marginal benefits and marginal costs.
CHAPTER 1
EXAMPLE
The Role and Environment of Managerial Finance
11
Jamie Teng is a financial manager for Nord Department Stores, a large chain of
upscale department stores operating primarily in the western United States. She is
currently trying to decide whether to replace one of the firm’s online computers
with a new, more sophisticated one that would both speed processing and handle
a larger volume of transactions. The new computer would require a cash outlay
of $80,000, and the old computer could be sold to net $28,000. The total benefits from the new computer (measured in today’s dollars) would be $100,000.
The benefits over a similar time period from the old computer (measured in
today’s dollars) would be $35,000. Applying marginal analysis, Jamie organizes
the data as follows:
Benefits with new computer
$100,000
Less: Benefits with old computer
35,000
(1) Marginal (added) benefits
Cost of new computer
$ 80,000
Less: Proceeds from sale of old computer
28,000
(2) Marginal (added) costs
Net benefit [(1) (2)]
$65,000
52,000
$13,000
Because the marginal (added) benefits of $65,000 exceed the marginal (added)
costs of $52,000, Jamie recommends that the firm purchase the new computer to
replace the old one. The firm will experience a net benefit of $13,000 as a result
of this action.
Relationship to Accounting
The firm’s finance (treasurer) and accounting (controller) activities are closely
related and generally overlap. Indeed, managerial finance and accounting are not
often easily distinguishable. In small firms the controller often carries out the
finance function, and in large firms many accountants are closely involved in various finance activities. However, there are two basic differences between finance
and accounting; one is related to the emphasis on cash flows and the other to
decision making.
Emphasis on Cash Flows
accrual basis
In preparation of financial
statements, recognizes revenue
at the time of sale and recognizes
expenses when they are
incurred.
cash basis
Recognizes revenues and
expenses only with respect to
actual inflows and outflows of
cash.
The accountant’s primary function is to develop and report data for measuring
the performance of the firm, assessing its financial position, and paying taxes.
Using certain standardized and generally accepted principles, the accountant prepares financial statements that recognize revenue at the time of sale (whether payment has been received or not) and recognize expenses when they are incurred.
This approach is referred to as the accrual basis.
The financial manager, on the other hand, places primary emphasis on cash
flows, the intake and outgo of cash. He or she maintains the firm’s solvency by planning the cash flows necessary to satisfy its obligations and to acquire assets needed
to achieve the firm’s goals. The financial manager uses this cash basis to recognize
the revenues and expenses only with respect to actual inflows and outflows of cash.
12
PART 1
Introduction to Managerial Finance
Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet its
obligations as they come due.
EXAMPLE
Nassau Corporation, a small yacht dealer, sold one yacht for $100,000 in the calendar year just ended. The yacht was purchased during the year at a total cost of
$80,000. Although the firm paid in full for the yacht during the year, at year-end
it has yet to collect the $100,000 from the customer. The accounting view and the
financial view of the firm’s performance during the year are given by the following income and cash flow statements, respectively.
Accounting View
(accrual basis)
Financial View
(cash basis)
Nassau Corporation
Income Statement
for the Year Ended 12/31
Nassau Corporation
Cash Flow Statement
for the Year Ended 12/31
Sales revenue
$100,000
Cash inflow
$
Less: Costs
80,000
$ 20,000
Less: Cash outflow
80,000
($80,000)
Net profit
Net cash flow
0
In an accounting sense Nassau Corporation is profitable, but in terms of
actual cash flow it is a financial failure. Its lack of cash flow resulted from the
uncollected account receivable of $100,000. Without adequate cash inflows to
meet its obligations, the firm will not survive, regardless of its level of profits.
Hint The primary emphasis
of accounting is on accrual
methods; the primary emphasis
of financial management is on
cash flow methods.
As the example shows, accrual accounting data do not fully describe the circumstances of a firm. Thus the financial manager must look beyond financial
statements to obtain insight into existing or developing problems. Of course,
accountants are well aware of the importance of cash flows, and financial managers use and understand accrual-based financial statements. Nevertheless, the
financial manager, by concentrating on cash flows, should be able to avoid insolvency and achieve the firm’s financial goals.
Decision Making
The second major difference between finance and accounting has to do with decision making. Accountants devote most of their attention to the collection and
presentation of financial data. Financial managers evaluate the accounting statements, develop additional data, and make decisions on the basis of their assessment of the associated returns and risks. Of course, this does not mean that
accountants never make decisions or that financial managers never gather data.
Rather, the primary focuses of accounting and finance are distinctly different.
Primary Activities of the Financial Manager
In addition to ongoing involvement in financial analysis and planning, the financial manager’s primary activities are making investment decisions and making
financing decisions. Investment decisions determine both the mix and the type of
CHAPTER 1
The Role and Environment of Managerial Finance
FIGURE 1.2
13
Balance Sheet
Financial Activities
Primary activities of the
financial manager
Making
Investment
Decisions
Current
Assets
Current
Liabilities
Fixed
Assets
Long-Term
Funds
Making
Financing
Decisions
assets held by the firm. Financing decisions determine both the mix and the type
of financing used by the firm. These sorts of decisions can be conveniently viewed
in terms of the firm’s balance sheet, as shown in Figure 1.2. However, the decisions are actually made on the basis of their cash flow effects on the overall value
of the firm.
Review Questions
1–7
What financial activities is the treasurer, or financial manager, responsible
for handling in the mature firm?
1–8 What is the primary economic principle used in managerial finance?
1–9 What are the major differences between accounting and finance with
respect to emphasis on cash flows and decision making?
1–10 What are the two primary activities of the financial manager that are
related to the firm’s balance sheet?
LG4
1.3 Goal of the Firm
As noted earlier, the owners of a corporation are normally distinct from its managers. Actions of the financial manager should be taken to achieve the objectives
of the firm’s owners, its stockholders. In most cases, if financial managers are
successful in this endeavor, they will also achieve their own financial and professional objectives. Thus financial managers need to know what the objectives of
the firm’s owners are.
Maximize Profit?
earnings per share (EPS)
The amount earned during the
period on behalf of each
outstanding share of common
stock, calculated by dividing the
period’s total earnings available
for the firm’s common stockholders by the number of shares of
common stock outstanding.
Some people believe that the firm’s objective is always to maximize profit. To
achieve this goal, the financial manager would take only those actions that were
expected to make a major contribution to the firm’s overall profits. For each
alternative being considered, the financial manager would select the one that is
expected to result in the highest monetary return.
Corporations commonly measure profits in terms of earnings per share
(EPS), which represent the amount earned during the period on behalf of each
outstanding share of common stock. EPS are calculated by dividing the period’s
total earnings available for the firm’s common stockholders by the number of
shares of common stock outstanding.
14
PART 1
Introduction to Managerial Finance
EXAMPLE
Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of
marine engine components, is choosing between two investments, Rotor and
Valve. The following table shows the EPS that each investment is expected to
have over its 3-year life.
Earnings per share (EPS)
Investment
Year 1
Year 2
Year 3
Total for years 1, 2, and 3
Rotor
$1.40
$1.00
$0.40
$2.80
Valve
0.60
1.00
1.40
3.00
In terms of the profit maximization goal, Valve would be preferred over
Rotor, because it results in higher total earnings per share over the 3-year period
($3.00 EPS compared with $2.80 EPS).
But is profit maximization a reasonable goal? No. It fails for a number of
reasons: It ignores (1) the timing of returns, (2) cash flows available to stockholders, and (3) risk.2
Timing
Because the firm can earn a return on funds it receives, the receipt of funds sooner
rather than later is preferred. In our example, in spite of the fact that the total
earnings from Rotor are smaller than those from Valve, Rotor provides much
greater earnings per share in the first year. The larger returns in year 1 could be
reinvested to provide greater future earnings.
Cash Flows
Profits do not necessarily result in cash flows available to the stockholders. Owners receive cash flow in the form of either cash dividends paid them or the proceeds from selling their shares for a higher price than initially paid. Greater EPS
do not necessarily mean that a firm’s board of directors will vote to increase dividend payments.
Furthermore, higher EPS do not necessarily translate into a higher stock
price. Firms sometimes experience earnings increases without any correspondingly favorable change in stock price. Only when earnings increases are accompanied by increased future cash flows would a higher stock price be expected. For
example, a firm in a highly competitive technology-driven business could increase
its earnings by significantly reducing its research and development expenditures.
As a result the firm’s expenses would be reduced, thereby increasing its profits.
But because of its impaired competitive position, the firm’s stock price would
drop, as many well-informed investors sell the stock in recognition of lower
future cash flows. In this case, the earnings increase was accompanied by lower
future cash flows and therefore a lower stock price.
2. Another criticism of profit maximization is the potential for profit manipulation through the creative use of elective accounting practices.
CHAPTER 1
The Role and Environment of Managerial Finance
15
Risk
risk
The chance that actual outcomes
may differ from those expected.
Hint This is one of the
most important concepts in the
book. Investors who seek to
avoid risk will always require a
bigger reward for taking bigger
risks.
risk-averse
Seeking to avoid risk.
Profit maximization also disregards risk—the chance that actual outcomes may
differ from those expected. A basic premise in managerial finance is that a tradeoff
exists between return (cash flow) and risk. Return and risk are in fact the key
determinants of share price, which represents the wealth of the owners in the firm.
Cash flow and risk affect share price differently: Higher cash flow is generally associated with a higher share price. Higher risk tends to result in a lower
share price because the stockholder must be compensated for the greater risk. For
example, if a lawsuit claiming significant damages is filed against a company, its
share price typically will drop immediately. This occurs not because of any nearterm cash flow reduction but in response to the firm’s increased risk—there’s a
chance that the firm will have to pay out a large amount of cash some time in the
future to eliminate or fully satisfy the claim. Simply put, the increased risk
reduces the firm’s share price. In general, stockholders are risk-averse—that is,
they want to avoid risk. When risk is involved, stockholders expect to earn higher
rates of return on investments of higher risk and lower rates on lower-risk investments. The key point, which will be fully developed in Chapter 5, is that differences in risk can significantly affect the value of an investment.
Because profit maximization does not achieve the objectives of the firm’s
owners, it should not be the goal of the financial manager.
Maximize Shareholder Wealth
The goal of the firm, and therefore of all managers and employees, is to maximize
the wealth of the owners for whom it is being operated. The wealth of corporate
owners is measured by the share price of the stock, which in turn is based on the
timing of returns (cash flows), their magnitude, and their risk. When considering
each financial decision alternative or possible action in terms of its impact on the
share price of the firm’s stock, financial managers should accept only those
actions that are expected to increase share price. Figure 1.3 depicts this process.
Because share price represents the owners’ wealth in the firm, maximizing share
price will maximize owner wealth. Note that return (cash flows) and risk are the
key decision variables in maximizing owner wealth. It is important to recognize
that earnings per share (EPS), because they are viewed as an indicator of the
FIGURE 1.3
Share Price
Maximization
Financial decisions and share
price
Financial
Manager
Financial
Decision
Alternative
or Action
Return?
Risk?
Increase
Share
Price?
No
Reject
Yes
Accept
16
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Introduction to Managerial Finance
FOCUS ON PRACTICE
Creating Shareholder Value and WaMu
Once a small Northwest thrift,
Washington Mutual (WaMu) is
now the nation’s largest savings
institution and the seventh largest
U.S. bank. Its financial performance has been as exceptional as
its rapid growth. Under the financial leadership of CFO William
Longbrake, its assets grew 10-fold
(to $220 billion) in a recent 5-year
period, earnings rose an average
of 18.6 percent per year, and the
stock price nearly tripled.
How has WaMu’s management team increased shareholder
value so much? Four major acquisitions played an important role in
adding branch networks. Greater
penetration in existing markets has
also been a driver. Another differentiating factor is the “pay for performance” plan that Longbrake
introduced. The compensation
plan encourages all employees,
from managers to tellers, to cross-
sell products and to give customers the highest level of service
possible. As a result, the number of
customers and the profits per customer have soared, helped along
by a clever advertising campaign
that emphasizes WaMu’s personal
service.
But it’s not enough to grow
revenues if expenses aren’t under
control. At the same time as its
revenues grew, the bank’s operating efficiency improved significantly, the best among WaMu’s
major competitors.
Longbrake and his financial
managers continually look for
ways to boost revenues and
improve earnings. A successful
campaign to increase noninterest
income from depositor and other
retail banking fees, which are not
subject to interest-rate movements, lessened the effect on
earnings of changes in interest
In Practice
rates. Another strategy was to sell
off all but the most profitable
single-family mortgages in the
bank’s loan portfolio. In spite of
interest-rate fluctuations in 2000,
WaMu earned $1.9 billion—its
most profitable year ever. The
bank continued to post record
results in 2001, as interest rates
fell, by increasing mortgage origination and refinancing activities.
As a result, the firm even
increased cash dividends at a time
when many companies were cutting them. Clearly, Longbrake and
his managers’ actions were effective in creating value for WaMu’s
shareholders.
Sources: Adapted from Stephen Barr, “The
Revenue Revolution at Washington Mutual,”
CFO, October 2001, downloaded from
www.cfo.com; “Washington Mutual Profits
Rise 84 Percent,” October 16, 2001, Reuters
Business Report, downloaded from eLibrary,
ask.elibrary.com; Washington Mutual Web
site, www.wamu.com.
firm’s future returns (cash flows), often appear to affect share price. Two important issues related to maximizing share price are economic value added (EVA®)
and the focus on stakeholders.
Economic Value Added (EVA®)
economic value added (EVA®)
A popular measure used by many
firms to determine whether an
investment contributes positively
to the owners’ wealth;
calculated by subtracting the
cost of funds used to finance an
investment from its after-tax
operating profits.
Economic value added (EVA®) is a popular measure used by many firms to determine whether an investment—proposed or existing—contributes positively to the
owners’ wealth.3 EVA® is calculated by subtracting the cost of funds used to
finance an investment from its after-tax operating profits. Investments with positive EVA®s increase shareholder value and those with negative EVA®s reduce
shareholder value. Clearly, only those investments with positive EVA®s are desirable. For example, the EVA® of an investment with after-tax operating profits of
$410,000 and associated financing costs of $375,000 would be $35,000 (i.e.,
$410,000 $375,000). Because this EVA® is positive, the investment is expected
to increase owner wealth and is therefore acceptable. (EVA®-type models are discussed in greater detail as part of the coverage of stock valuation in Chapter 7.)
3. For a good summary of economic value added (EVA®), see Shaun Tully, “The Real Key to Creating Wealth,”
Fortune (September 20, 1993), pp. 38–49.
CHAPTER 1
The Role and Environment of Managerial Finance
17
What About Stakeholders?
stakeholders
Groups such as employees,
customers, suppliers, creditors,
owners, and others who have a
direct economic link to the firm.
Although maximization of shareholder wealth is the primary goal, many firms
broaden their focus to include the interests of stakeholders as well as shareholders.
Stakeholders are groups such as employees, customers, suppliers, creditors, owners,
and others who have a direct economic link to the firm. A firm with a stakeholder
focus consciously avoids actions that would prove detrimental to stakeholders. The
goal is not to maximize stakeholder well-being but to preserve it.
The stakeholder view does not alter the goal of maximizing shareholder
wealth. Such a view is often considered part of the firm’s “social responsibility.”
It is expected to provide long-run benefit to shareholders by maintaining positive
stakeholder relationships. Such relationships should minimize stakeholder
turnover, conflicts, and litigation. Clearly, the firm can better achieve its goal of
shareholder wealth maximization by fostering cooperation with its other stakeholders, rather than conflict with them.
The Role of Ethics
ethics
Standards of conduct or moral
judgment.
In recent years, the ethics of actions taken by certain businesses have received major
media attention. Examples include an agreement by American Express Co. in early
2002 to pay $31 million to settle a sex- and age-discrimination lawsuit filed on
behalf of more than 4,000 women who said they were denied equal pay and promotions; Enron Corp.’s key executives indicating to employee-shareholders in mid2001 that the firm’s then-depressed stock price would soon recover while, at the
same time, selling their own shares and, not long after, taking the firm into bankruptcy; and Liggett & Meyers’ early 1999 agreement to fund the payment of more
than $1 billion in smoking-related health claims.
Clearly, these and similar actions have raised the question of ethics—standards
of conduct or moral judgment. Today, the business community in general and the
financial community in particular are developing and enforcing ethical standards.
The goal of these ethical standards is to motivate business and market participants
to adhere to both the letter and the spirit of laws and regulations concerned with
business and professional practice. Most business leaders believe businesses actually strengthen their competitive positions by maintaining high ethical standards.
Considering Ethics
Robert A. Cooke, a noted ethicist, suggests that the following questions be used
to assess the ethical viability of a proposed action.4
1. Is the action arbitrary or capricious? Does it unfairly single out an individual
or group?
2. Does the action violate the moral or legal rights of any individual or group?
3. Does the action conform to accepted moral standards?
4. Are there alternative courses of action that are less likely to cause actual or
potential harm?
4. Robert A. Cooke, “Business Ethics: A Perspective,” in Arthur Andersen Cases on Business Ethics (Chicago:
Arthur Andersen, September 1991), pp. 2 and 5.
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Introduction to Managerial Finance
FOCUS ON ETHICS
In Practice
“Doing Well by Doing Good”
Hewlett-Packard (H-P) was
founded in 1939 by Bill Hewlett and
Dave Packard on the basis of principles of fair dealing and
respect—long before anyone
coined the expression “corporate
social responsibility.” H-P credits
its ongoing commitment to “doing
well by doing good” as a major
reason why employees, suppliers,
customers, and shareholders seek
it out. H-P is clear on its obligation
to increase the market value of its
common stock, yet it strives to
maintain the integrity of each
employee in every country in
which it does business. Its
“Standards of Business Conduct”
include a provision that triggers
immediate dismissal of any
employee who is found to have
told a lie. Its internal auditors are
expected to adhere to all of these
standards, which set forth the
“highest principles of business
ethics and conduct,” according to
H-P’s 2000 annual report.
Maximizing shareholder
wealth is what some call a “moral
imperative,” in that stockholders
are owners with property rights,
and in that managers as stewards
are obliged to look out for owners’
interests. Many times, doing what
is right is consistent with maximizing the stock price, but what if
integrity causes a company to lose
a contract or causes analysts to
reduce the rating of the stock from
“buy” to “sell”? The objective to
maximize shareholder wealth
holds, but company officers must
do so within ethical constraints.
Those constraints occasionally
limit the alternative actions from
which managers may choose.
Some critics have mistakenly
assumed that the objective of maximizing shareholder wealth is
somehow the cause of unethical
behavior, ignoring the fact that any
business goal might be cited as a
factor pressuring individuals to be
unethical.
U.S. business professionals
have tended to operate from within
a strong moral framework based
on early-childhood moral development that takes place in families
and religious institutions. This
does not prevent all ethical lapses,
obviously. But it is not surprising
that chief financial officers declare
that the number-1 personal
attribute that finance grads need is
ethics—which they rank above
interpersonal skills, communication skills, decision-making ability,
and computer skills. H-P is aware
of this need and has institutionalized it in the company’s culture
and policies.
Clearly, considering such questions before taking an action can help to
ensure its ethical viability. Specifically, Cooke suggests that the impact of a proposed decision should be evaluated from a number of perspectives before it is
finalized:
1. Are the rights of any stakeholder being violated?
2. Does the firm have any overriding duties to any stakeholder?
3. Will the decision benefit any stakeholder to the detriment of another
stakeholder?
4. If there is detriment to any stakeholder, how should this be remedied, if at
all?
5. What is the relationship between stockholders and other stakeholders?
Today, more and more firms are directly addressing the issue of ethics by
establishing corporate ethics policies and requiring employee compliance with
them. Frequently, employees are required to sign a formal pledge to uphold the
firm’s ethics policies. Such policies typically apply to employee actions in dealing
with all corporate stakeholders, including the public. Many companies also
require employees to participate in ethics seminars and training programs. To
provide further insight into the ethical dilemmas and issues sometimes facing the
CHAPTER 1
The Role and Environment of Managerial Finance
19
financial manager, a number of the In Practice boxes appearing throughout this
book are labeled to note their focus on ethics.
Ethics and Share Price
An effective ethics program is believed to enhance corporate value. An ethics program can produce a number of positive benefits. It can reduce potential litigation
and judgment costs; maintain a positive corporate image; build shareholder confidence; and gain the loyalty, commitment, and respect of the firm’s stakeholders.
Such actions, by maintaining and enhancing cash flow and reducing perceived
risk, can positively affect the firm’s share price. Ethical behavior is therefore
viewed as necessary for achieving the firm’s goal of owner wealth maximization.5
The Agency Issue
Hint A stockbroker
confronts the same issue. If she
gets you to buy and sell more
stock, it’s good for her, but it
may not be good for you.
We have seen that the goal of the financial manager should be to maximize the
wealth of the firm’s owners. Thus managers can be viewed as agents of the owners who have hired them and given them decision-making authority to manage
the firm. Technically, any manager who owns less than 100 percent of the firm is
to some degree an agent of the other owners. This separation of owners and managers is shown by the dashed horizontal line in Figure 1.1 on page 7.
In theory, most financial managers would agree with the goal of owner
wealth maximization. In practice, however, managers are also concerned with
their personal wealth, job security, and fringe benefits. Such concerns may make
managers reluctant or unwilling to take more than moderate risk if they perceive
that taking too much risk might jeopardize their jobs or reduce their personal
wealth. The result is a less-than-maximum return and a potential loss of wealth
for the owners.
The Agency Problem
agency problem
The likelihood that managers
may place personal goals ahead
of corporate goals.
From this conflict of owner and personal goals arises what has been called the
agency problem, the likelihood that managers may place personal goals ahead of
corporate goals.6 Two factors—market forces and agency costs—serve to prevent
or minimize agency problems.
Market Forces One market force is major shareholders, particularly large
institutional investors such as mutual funds, life insurance companies, and
pension funds. These holders of large blocks of a firm’s stock exert pressure on
management to perform. When necessary, they exercise their voting rights as
stockholders to replace underperforming management.
5. For an excellent discussion of this and related issues by a number of finance academics and practitioners who have
given a lot of thought to financial ethics, see James S. Ang, “On Financial Ethics,” Financial Management (Autumn
1993), pp. 32–59.
6. The agency problem and related issues were first addressed by Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3
(October 1976), pp. 305–306. For an excellent discussion of Jensen and Meckling and subsequent research on the
agency problem, see William L. Megginson, Corporate Finance Theory (Boston, MA: Addison Wesley, 1997),
Chapter 2.
20
PART 1
Introduction to Managerial Finance
agency costs
The costs borne by stockholders
to minimize agency problems.
incentive plans
Management compensation
plans that tend to tie management compensation to share
price; most popular incentive
plan involves the grant of stock
options.
stock options
An incentive allowing managers
to purchase stock at the market
price set at the time of the grant.
performance plans
Plans that tie management
compensation to measures such
as EPS, growth in EPS, and other
ratios of return. Performance
shares and/or cash bonuses are
used as compensation under
these plans.
performance shares
Shares of stock given to management for meeting stated performance goals.
cash bonuses
Cash paid to management for
achieving certain performance
goals.
Another market force is the threat of takeover by another firm that believes it
can enhance the target firm’s value to restructuring its management, operations,
and financing.7 The constant threat of a takeover tends to motivate management
to act in the best interests of the firm’s owners.
Agency Costs To minimize agency problems and contribute to the maximization of owners’ wealth, stockholders incur agency costs. These are the costs
of monitoring management behavior, ensuring against dishonest acts of management, and giving managers the financial incentive to maximize share price.
The most popular, powerful, and expensive approach is to structure management compensation to correspond with share price maximization. The objective
is to give managers incentives to act in the best interests of the owners. In addition, the resulting compensation packages allow firms to compete for and hire the
best managers available. The two key types of compensation plans are incentive
plans and performance plans.
Incentive plans tend to tie management compensation to share price. The
most popular incentive plan is the granting of stock options to management.
These options allow managers to purchase stock at the market price set at the
time of the grant. If the market price rises, managers will be rewarded by being
able to resell the shares at the higher market price.
Many firms also offer performance plans, which tie management compensation to measures such as earnings per share (EPS), growth in EPS, and other
ratios of return. Performance shares, shares of stock given to management as a
result of meeting the stated performance goals, are often used in these plans.
Another form of performance-based compensation is cash bonuses, cash payments tied to the achievement of certain performance goals.
The Current View of Management Compensation
The execution of many compensation plans has been closely scrutinized in recent
years. Both individuals and institutional stockholders, as well as the Securities
and Exchange Commission (SEC), have publicly questioned the appropriateness
of the multimillion-dollar compensation packages that many corporate executives
receive. For example, the three highest-paid CEOs in 2001 were (1) Lawrence
Ellison, of Oracle, who earned $706.1 million; (2) Jozef Straus, of JDS Uniphase,
who earned $150.8 million; and (3) Howard Solomon, of Forest Laboratories,
who earned $148.5 million. Tenth on the same list was Timothy Koogle, of
Yahoo!, who earned $64.6 million. During 2001, the compensation of the average
CEO of a major U.S. corporation declined by about 16 percent from 2000. CEOs
of 365 of the largest U.S. companies surveyed by Business Week, using data from
Standard & Poor’s EXECUCOMP, earned an average of $11 million in total compensation; the average for the 20 highest paid CEOs was $112.5 million.
Recent studies have failed to find a strong relationship between CEO compensation and share price. Publicity surrounding these large compensation packages (without corresponding share price performance) is expected to drive down
7. Detailed discussion of the important aspects of corporate takeovers is included in Chapter 17, “Mergers, LBOs,
Divestitures, and Business Failure.”
CHAPTER 1
The Role and Environment of Managerial Finance
21
executive compensation in the future. Contributing to this publicity is the SEC
requirement that publicly traded companies disclose to shareholders and others
both the amount of compensation to their highest paid executives and the
method used to determine it. At the same time, new compensation plans that better link managers’ performance with regard to shareholder wealth to their compensation are expected to be developed and implemented.
Unconstrained, managers may have other goals in addition to share price
maximization, but much of the evidence suggests that share price maximization—the focus of this book—is the primary goal of most firms.
Review Questions
1–11 For what three basic reasons is profit maximization inconsistent with
wealth maximization?
1–12 What is risk? Why must risk as well as return be considered by the financial manager who is evaluating a decision alternative or action?
1–13 What is the goal of the firm and therefore of all managers and employees?
Discuss how one measures achievement of this goal.
1–14 What is economic value added (EVA®)? How is it used?
1–15 Describe the role of corporate ethics policies and guidelines, and discuss
the relationship that is believed to exist between ethics and share price.
1–16 How do market forces, both shareholder activism and the threat of
takeover, act to prevent or minimize the agency problem?
1–17 Define agency costs, and explain why firms incur them. How can management structure management compensation to minimize agency problems?
What is the current view with regard to the execution of many compensation plans?
LG5
1.4 Financial Institutions and Markets
financial institution
An intermediary that channels
the savings of individuals,
businesses, and governments
into loans or investments.
Hint Think about how
inefficient it would be if each
individual saver had to
negotiate with each potential
user of savings. Institutions
make the process very efficient
by becoming intermediaries
between savers and users.
Most successful firms have ongoing needs for funds. They can obtain funds from
external sources in three ways. One is through a financial institution that accepts
savings and transfers them to those that need funds. Another is through financial
markets, organized forums in which the suppliers and demanders of various types
of funds can make transactions. A third is through private placement. Because of
the unstructured nature of private placements, here we focus primarily on financial institutions and financial markets.
Financial Institutions
Financial institutions serve as intermediaries by channeling the savings of individuals, businesses, and governments into loans or investments. Many financial
institutions directly or indirectly pay savers interest on deposited funds; others
provide services for a fee (for example, checking accounts for which customers
pay service charges). Some financial institutions accept customers’ savings
deposits and lend this money to other customers or to firms; others invest
22
PART 1
Introduction to Managerial Finance
customers’ savings in earning assets such as real estate or stocks and bonds; and
some do both. Financial institutions are required by the government to operate
within established regulatory guidelines.
Key Customers of Financial Institutions
The key suppliers of funds to financial institutions and the key demanders of
funds from financial institutions are individuals, businesses, and governments.
The savings that individual consumers place in financial institutions provide
these institutions with a large portion of their funds. Individuals not only supply
funds to financial institutions but also demand funds from them in the form of
loans. However, individuals as a group are the net suppliers for financial institutions: They save more money than they borrow.
Business firms also deposit some of their funds in financial institutions, primarily in checking accounts with various commercial banks. Like individuals,
firms also borrow funds from these institutions, but firms are net demanders of
funds. They borrow more money than they save.
Governments maintain deposits of temporarily idle funds, certain tax payments, and Social Security payments in commercial banks. They do not borrow
funds directly from financial institutions, although by selling their debt securities
to various institutions, governments indirectly borrow from them. The government, like business firms, is typically a net demander of funds. It typically borrows more than it saves. We’ve all heard about the federal budget deficit.
Major Financial Institutions
WW
W
The major financial institutions in the U.S. economy are commercial banks, savings and loans, credit unions, savings banks, insurance companies, pension funds,
and mutual funds. These institutions attract funds from individuals, businesses,
and governments, combine them, and make loans available to individuals and
businesses. Descriptions of the major financial institutions are found at the textbook’s Web site at www.aw.com/gitman.
Financial Markets
financial markets
Forums in which suppliers of
funds and demanders of funds
can transact business directly.
private placement
The sale of a new security issue,
typically bonds or preferred
stock, directly to an investor or
group of investors.
public offering
The nonexclusive sale of either
bonds or stocks to the general
public.
Financial markets are forums in which suppliers of funds and demanders of funds
can transact business directly. Whereas the loans and investments of institutions
are made without the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or invested.
The two key financial markets are the money market and the capital market.
Transactions in short-term debt instruments, or marketable securities, take place
in the money market. Long-term securities—bonds and stocks—are traded in the
capital market.
To raise money, firms can use either private placements or public offerings.
Private placement involves the sale of a new security issue, typically bonds or preferred stock, directly to an investor or group of investors, such as an insurance
company or pension fund. Most firms, however, raise money through a public
offering of securities, which is the nonexclusive sale of either bonds or stocks to
the general public.
CHAPTER 1
primary market
Financial market in which
securities are initially issued; the
only market in which the issuer
is directly involved in the
transaction.
secondary market
Financial market in which
preowned securities (those that
are not new issues) are traded.
The Role and Environment of Managerial Finance
23
All securities are initially issued in the primary market. This is the only market in which the corporate or government issuer is directly involved in the transaction and receives direct benefit from the issue. That is, the company actually
receives the proceeds from the sale of securities. Once the securities begin to trade
between savers and investors, they become part of the secondary market. The primary market is the one in which “new” securities are sold. The secondary market
can be viewed as a “preowned” securities market.
The Relationship Between Institutions and Markets
Financial institutions actively participate in the financial markets as both suppliers
and demanders of funds. Figure 1.4 depicts the general flow of funds through and
between financial institutions and financial markets; private placement transactions are also shown. The individuals, businesses, and governments that supply
and demand funds may be domestic or foreign. We next briefly discuss the money
market, including its international equivalent—the Eurocurrency market. We then
end this section with a discussion of the capital market, which is of key importance
to the firm.
The Money Market
FIGURE 1.4
Flow of Funds
Flow of funds for financial
institutions and markets
Funds
Funds
Financial
Institutions
Deposits/Shares
Loans
Suppliers
of Funds
Securities
Funds
Private
Placement
Demanders
of Funds
Securities
marketable securities
Short-term debt instruments,
such as U.S. Treasury bills,
commercial paper, and
negotiable certificates of deposit
issued by government, business,
and financial institutions,
respectively.
The money market is created by a financial relationship between suppliers and
demanders of short-term funds (funds with maturities of one year or less). The
money market exists because some individuals, businesses, governments, and
financial institutions have temporarily idle funds that they wish to put to some
interest-earning use. At the same time, other individuals, businesses, governments, and financial institutions find themselves in need of seasonal or temporary
financing. The money market brings together these suppliers and demanders of
short-term funds.
Most money market transactions are made in marketable securities—shortterm debt instruments, such as U.S. Treasury bills, commercial paper, and
Funds
money market
A financial relationship created
between suppliers and
demanders of short-term funds.
Funds
Securities
Financial
Markets
Funds
Securities
24
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Introduction to Managerial Finance
negotiable certificates of deposit issued by government, business, and financial
institutions, respectively. (Marketable securities are described in Chapter 14.)
The Operation of the Money Market
federal funds
Loan transactions between
commercial banks in which the
Federal Reserve banks become
involved.
Hint Remember that the
money market is for short-term
fund raising and is represented
by current liabilities on the
balance sheet. The capital
market is for long-term fund
raising and is reflected by longterm debt and equity on the
balance sheet.
The money market is not an actual organization housed in some central location.
How, then, are suppliers and demanders of short-term funds brought together?
Typically, they are matched through the facilities of large New York banks and
through government securities dealers. A number of stock brokerage firms purchase money market instruments for resale to customers. Also, financial institutions purchase money market instruments for their portfolios in order to provide
attractive returns on their customers’ deposits and share purchases. Additionally,
the Federal Reserve banks become involved in loans from one commercial bank
to another; these loans are referred to as transactions in federal funds.
In the money market, businesses and governments demand short-term funds
(borrow) by issuing a money market instrument. Parties who supply short-term
funds (invest) purchase the money market instruments. To issue or purchase a
money market instrument, one party must go directly to another party or use an
intermediary, such as a bank or brokerage firm, to make the transaction. The secondary (resale) market for marketable securities is no different from the primary
(initial issue) market with respect to the basic transactions that are made. Individuals also participate in the money market as purchasers and sellers of money market instruments. Although individuals do not issue marketable securities, they
may sell them in the money market to liquidate them prior to maturity.
The Eurocurrency Market
Eurocurrency market
International equivalent of the
domestic money market.
London Interbank Offered Rate
(LIBOR)
The base rate that is used to
price all Eurocurrency loans.
The international equivalent of the domestic money market is called the
Eurocurrency market. This is a market for short-term bank deposits denominated in U.S. dollars or other easily convertible currencies. Historically, the
Eurocurrency market has been centered in London, but it has evolved into a
truly global market.
Eurocurrency deposits arise when a corporation or individual makes a bank
deposit in a currency other than the local currency of the country where the bank
is located. If, for example, a multinational corporation were to deposit U.S. dollars in a London bank, this would create a Eurodollar deposit (a dollar deposit at
a bank in Europe). Nearly all Eurodollar deposits are time deposits. This means
that the bank would promise to repay the deposit, with interest, at a fixed date in
the future—say, in 6 months. During the interim, the bank is free to lend this
dollar deposit to creditworthy corporate or government borrowers. If the bank
cannot find a borrower on its own, it may lend the deposit to another international bank. The rate charged on these “interbank loans” is called the London
Interbank Offered Rate (LIBOR), and this is the base rate that is used to price all
Eurocurrency loans.
The Eurocurrency market has grown rapidly, primarily because it is an
unregulated, wholesale, and global market that fills the needs of both borrowers
and lenders. Investors with excess cash to lend are able to make large, short-term,
and safe deposits at attractive interest rates. Likewise, borrowers are able to
arrange large loans, quickly and confidentially, also at attractive interest rates.
CHAPTER 1
The Role and Environment of Managerial Finance
25
The Capital Market
capital market
A market that enables suppliers
and demanders of long-term
funds to make transactions.
The capital market is a market that enables suppliers and demanders of long-term
funds to make transactions. Included are securities issues of business and government. The backbone of the capital market is formed by the various securities
exchanges that provide a forum for bond and stock transactions.
Key Securities Traded: Bonds and Stocks
bond
Long-term debt instrument used
by business and government to
raise large sums of money,
generally from a diverse group of
lenders.
EXAMPLE
preferred stock
A special form of ownership
having a fixed periodic dividend
that must be paid prior to
payment of any common stock
dividends.
The key capital market securities are bonds (long-term debt) and both common
and preferred stock (equity, or ownership). Bonds are long-term debt instruments
used by business and government to raise large sums of money, generally from a
diverse group of lenders. Corporate bonds typically pay interest semiannually
(every 6 months) at a stated coupon interest rate. They have an initial maturity of
from 10 to 30 years, and a par, or face, value of $l,000 that must be repaid at
maturity. Bonds are described in detail in Chapter 6.
Lakeview Industries, a major microprocessor manufacturer, has issued a 9 percent coupon interest rate, 20-year bond with a $1,000 par value that pays interest
semiannually. Investors who buy this bond receive the contractual right to $90
annual interest (9% coupon interest rate $1,000 par value) distributed as $45
at the end of each 6 months (1/2 $90) for 20 years, plus the $1,000 par value at
the end of year 20.
As noted earlier, shares of common stock are units of ownership, or equity,
in a corporation. Common stockholders earn a return by receiving dividends—
periodic distributions of earnings—or by realizing increases in share price. Preferred stock is a special form of ownership that has features of both a bond and
common stock. Preferred stockholders are promised a fixed periodic dividend
that must be paid prior to payment of any dividends to common stockholders. In
other words, preferred stock has “preference” over common stock. Preferred and
common stock are described in detail in Chapter 7.
Major Securities Exchanges
securities exchanges
Organizations that provide the
marketplace in which firms can
raise funds through the sale of
new securities and purchasers
can resell securities.
Securities exchanges provide the marketplace in which firms can raise funds
through the sale of new securities and purchasers of securities can easily resell
them when necessary. Many people call securities exchanges “stock markets,”
but this label is misleading because bonds, common stock, preferred stock, and a
variety of other investment vehicles are all traded on these exchanges. The two
key types of securities exchanges are the organized exchange and the over-thecounter exchange. In addition, important markets exist outside the United
States.
organized securities exchanges
Tangible organizations that act
as secondary markets where
outstanding securities are
resold.
Organized Securities Exchanges Organized securities exchanges are tangible organizations that act as secondary markets where outstanding securities are
resold. Organized exchanges account for about 46 percent of the total dollar volume of domestic shares traded. The best-known organized exchanges are the
New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX),
26
PART 1
Introduction to Managerial Finance
both headquartered in New York City. There are also regional exchanges, such
as the Chicago Stock Exchange and the Pacific Stock Exchange.
Most exchanges are modeled after the New York Stock Exchange, which
accounts for about 93 percent of the total annual dollar volume of shares traded
on organized U.S. exchanges. In order for a firm’s securities to be listed for trading on an organized exchange, a firm must file an application for listing and meet
a number of requirements. For example, to be eligible for listing on the NYSE, a
firm must have at least 2,000 stockholders owning 100 or more shares; a minimum of 1.1 million shares of publicly held stock; pretax earnings of at least $6.5
million over the previous 3 years, with no loss in the previous 2 years; and a minimum of $100 million in stockholders’ equity. Clearly, only large, widely held
firms are candidates for NYSE listing.
To make transactions on the “floor” of the New York Stock Exchange, an
individual or firm must own a “seat” on the exchange. There are a total of 1,366
seats on the NYSE, most of which are owned by brokerage firms. Trading is carried out on the floor of the exchange through an auction process. The goal of trading is to fill buy orders at the lowest price and to fill sell orders at the highest price,
thereby giving both purchasers and sellers the best possible deal.
Once placed, an order to buy or sell can be executed in minutes, thanks to
sophisticated telecommunication devices. New Internet-based brokerage systems
enable investors to place their buy and sell orders electronically. Information on
publicly traded securities is reported in various media, both print, such as the Wall
Street Journal, and electronic, such as MSN Money Central Investor (www.
moneycentral.msn.com).
over-the-counter (OTC) exchange
An intangible market for the
purchase and sale of securities
not listed by the organized
exchanges.
Eurobond market
The market in which corporations and governments typically
issue bonds denominated in
dollars and sell them to investors
located outside the United
States.
The Over-the-Counter Exchange The over-the-counter (OTC) exchange is
an intangible market for the purchase and sale of securities not listed by the organized exchanges. OTC traders, known as dealers, are linked with the purchasers
and sellers of securities through the National Association of Securities Dealers
Automated Quotation (Nasdaq) system.
This sophisticated telecommunications network provides current bid and ask
prices on thousands of actively traded OTC securities. The bid price is the highest
price offered by a dealer to purchase a given security, and the ask price is the lowest price at which the dealer is willing to sell the security. The dealer in effect adds
securities to his or her inventory by purchasing them at the bid price and sells
securities from the inventory at the ask price. The dealer expects to profit from
the spread between the bid and ask prices. Unlike the auction process on the
organized securities exchanges, the prices at which securities are traded in the
OTC market result from both competitive bids and negotiation.
Unlike the organized exchanges, the OTC handles both outstanding securities and new public issues, making it both a secondary and a primary market. The
OTC accounts for about 54 percent of the total dollar volume of domestic shares
traded.
International Capital Markets Although U.S. capital markets are by far the
world’s largest, there are important debt and equity markets outside the United
States. In the Eurobond market, corporations and governments typically issue
bonds denominated in dollars and sell them to investors located outside the
United States. A U.S. corporation might, for example, issue dollar-denominated
CHAPTER 1
foreign bond
Bond that is issued by a foreign
corporation or government and is
denominated in the investor’s
home currency and sold in the
investor’s home market.
international equity market
A market that allows corporations to sell blocks of shares to
investors in a number of different
countries simultaneously.
27
The Role and Environment of Managerial Finance
bonds that would be purchased by investors in Belgium, Germany, or Switzerland.
Through the Eurobond market, issuing firms and governments can tap a much
larger pool of investors than would be generally available in the local market.
The foreign bond market is another international market for long-term debt
securities. A foreign bond is a bond issued by a foreign corporation or government that is denominated in the investor’s home currency and sold in the
investor’s home market. A bond issued by a U.S. company that is denominated in
Swiss francs and sold in Switzerland is an example of a foreign bond. Although
the foreign bond market is much smaller than the Eurobond market, many issuers
have found this to be an attractive way of tapping debt markets in Germany,
Japan, Switzerland, and the United States.
Finally, the international equity market allows corporations to sell blocks of
shares to investors in a number of different countries simultaneously. This market enables corporations to raise far larger amounts of capital than they could
raise in any single national market. International equity sales have also proven to
be indispensable to governments that have sold state-owned companies to private
investors during recent years.
The Role of Securities Exchanges
Securities exchanges create continuous liquid markets in which firms can obtain
needed financing. They also create efficient markets that allocate funds to their
most productive uses. This is especially true for securities that are actively traded
on major exchanges, where the competition among wealth-maximizing investors
determines and publicizes prices that are believed to be close to their true value.
The price of an individual security is determined by the demand for and
supply of the security. Figure 1.5 depicts the interaction of the forces of demand
(represented by line D0) and supply (represented by line S) for a given security
currently selling at an equilibrium price P0. At that price, Q0 shares of the stock
are traded.
Changing evaluations of a firm’s prospects cause changes in the demand for
and supply of its securities and ultimately result in a new price for the securities.
FIGURE 1.5
Supply and Demand
Supply and demand for a
security
D0
Share Price
efficient market
A market that allocates funds to
their most productive uses as a
result of competition among
wealth-maximizing investors that
determines and publicizes prices
that are believed to be close to
their true value.
D1
S
P1
P0
S
D0
D1
Q0 Q1
Number of Shares Traded
28
PART 1
Introduction to Managerial Finance
Suppose, for example, that the firm shown in Figure 1.5 announces a favorable
discovery. Investors expect rewarding results from the discovery, so they increase
their valuations of the firm’s shares. The changing evaluation results in a shift in
demand from D0 to D1. At that new level of demand, Q1 shares will be traded,
and a new, higher equilibrium price of P1 will result. The competitive market created by the major securities exchanges provides a forum in which share price is
continuously adjusted to changing demand and supply.
Review Questions
1–18 Who are the key participants in the transactions of financial institutions?
Who are net suppliers and who are net demanders?
1–19 What role do financial markets play in our economy? What are primary
and secondary markets? What relationship exists between financial institutions and financial markets?
1–20 What is the money market? How does it work?
1–21 What is the Eurocurrency market? What is the London Interbank Offered
Rate (LIBOR) and how is it used in this market?
1–22 What is the capital market? What are the primary securities traded in it?
1–23 What role do securities exchanges play in the capital market? How does
the over-the-counter exchange operate? How does it differ from the organized securities exchanges?
1–24 Briefly describe the international capital markets, particularly the
Eurobond market and the international equity market.
1–25 What are efficient markets? What determines the price of an individual
security in such a market?
LG6
1.5 Business Taxes
Taxes are a fact of life, and businesses, like individuals, must pay taxes on
income. The income of sole proprietorships and partnerships is taxed as the
income of the individual owners; corporate income is subject to corporate taxes.
Regardless of their legal form, all businesses can earn two types of income: ordinary and capital gains. Under current law, these two types of income are treated
differently in the taxation of individuals; they are not treated differently for entities subject to corporate taxes. Frequent amendments in the tax code, such as the
Economic Growth and Tax Relief Reconciliation Act of 2001 (reflected in the
following discussions), make it likely that these rates will change before the next
edition of this text is published. Emphasis here is given to corporate taxation.
Ordinary Income
ordinary income
Income earned through the sale
of a firm’s goods or services.
The ordinary income of a corporation is income earned through the sale of goods
or services. Ordinary income is currently taxed subject to the rates depicted in the
corporate tax rate schedule in Table 1.4.
CHAPTER 1
TABLE 1.4
The Role and Environment of Managerial Finance
29
Corporate Tax Rate Schedule
Tax calculation
(Marginal rate amount over base bracket)
0
7,500
13,750
(15% amount over $
(25 amount over
(34 amount over
22,250
113,900
3,400,000
(39
(34
(35
Range of taxable income
$
0
50,000
75,000
100,000
to $
to
to
to
50,000
75,000
100,000
335,000a
335,000 to 10,000,000
Over $10,000,000
Base tax
$
0)
50,000)
75,000)
amount over
100,000)
amount over
335,000)
amount over 10,000,000)
aBecause corporations with taxable income in excess of $100,000 must increase their tax by the lesser of
$11,750 or 5% of the taxable income in excess of $100,000, they will end up paying a 39% tax on taxable
income between $100,000 and $335,000. The 5% surtax that raises the tax rate from 34% to 39% causes all
corporations with taxable income between $335,000 and $10,000,000 to have an average tax rate of 34%.
EXAMPLE
Webster Manufacturing, Inc., a small manufacturer of kitchen knives, has beforetax earnings of $250,000. The tax on these earnings can be found by using the
tax rate schedule in Table 1.4:
Total taxes due $22,250 [0.39 ($250,000 $100,000)]
$22,250 (0.39 $150,000)
$22,250 $58,500 $80,750
From a financial point of view, it is important to understand the difference
between average and marginal tax rates, the treatment of interest and dividend
income, and the effects of tax deductibility.
Average Versus Marginal Tax Rates
average tax rate
A firm’s taxes divided by its
taxable income.
marginal tax rate
The rate at which additional
income is taxed.
The average tax rate paid on the firm’s ordinary income can be calculated by
dividing its taxes by its taxable income. For firms with taxable income of
$10,000,000 or less, the average tax rate ranges from 15 to 34 percent, reaching
34 percent when taxable income equals or exceeds $335,000. For firms with
taxable income in excess of $10,000,000, the average tax rate ranges between 34
and 35 percent. The average tax rate paid by Webster Manufacturing, Inc., in the
preceding example was 32.3 percent ($80,750 $250,000). As a corporation’s
taxable income increases, its average tax rate approaches and finally reaches 34
percent. It remains at that level up to $10,000,000 of taxable income, beyond
which it rises toward but never reaches 35 percent.
The marginal tax rate represents the rate at which additional income is taxed.
In the current corporate tax structure, the marginal tax rate on income up to
$50,000 is 15 percent; from $50,000 to $75,000 it is 25 percent; and so on, as
shown in Table 1.4. Webster Manufacturing’s marginal tax rate is currently 39
percent because its next dollar of taxable income (bringing its before-tax earnings
to $250,001) would be taxed at that rate. To simplify calculations in the text, a
fixed 40 percent tax rate is assumed to be applicable to ordinary corporate
income. Given our focus on financial decision making, this rate is assumed to represent the firm’s marginal tax rate.
30
PART 1
Introduction to Managerial Finance
Interest and Dividend Income
double taxation
Occurs when the already oncetaxed earnings of a corporation
are distributed as cash dividends
to stockholders, who must pay
taxes on them.
intercorporate dividends
Dividends received by one
corporation on common and
preferred stock held in other
corporations.
EXAMPLE
In the process of determining taxable income, any interest received by the corporation is included as ordinary income. Dividends, on the other hand, are treated
differently. This different treatment moderates the effect of double taxation,
which occurs when the already once-taxed earnings of a corporation are distributed as cash dividends to stockholders, who must pay taxes on them. Therefore,
dividends that the firm receives on common and preferred stock held in other corporations, and representing less than 20 percent ownership in them, are subject
to a 70 percent exclusion for tax purposes.8
Because of the dividend exclusion, only 30 percent of these intercorporate
dividends are included as ordinary income. The tax law provides this exclusion to
avoid triple taxation. Triple taxation would occur if the first and second corporations were taxed on income before the second corporation paid dividends to its
shareholders, who must then include the dividends in their taxable incomes. The
dividend exclusion in effect eliminates most of the potential tax liability from the
dividends received by the second and any subsequent corporations.
Charnes Industries, a large foundry that makes custom castings for the automobile industry, during the year just ended received $100,000 in interest on bonds it
held and $100,000 in dividends on common stock it owned in other corporations. The firm is subject to a 40% marginal tax rate and is eligible for a 70%
exclusion on its intercorporate dividend receipts. The after-tax income realized
by Charnes from each of these sources of investment income is found as follows:
Interest income
(1) Before-tax amount
$100,000
Less: Applicable exclusion
0
$100,000
Taxable amount
(2) Tax (40%)
After-tax amount [(1) (2)]
40,000
$ 60,000
Dividend income
$100,000
(0.70 $100,000) 70,000
$ 30,000
12,000
$ 88,000
As a result of the 70% dividend exclusion, the after-tax amount is greater for the
dividend income than for the interest income. Clearly, the dividend exclusion
enhances the attractiveness of stock investments relative to bond investments
made by one corporation in another.
Tax-Deductible Expenses
In calculating their taxes, corporations are allowed to deduct operating expenses,
as well as interest expense. The tax deductibility of these expenses reduces their
after-tax cost. The following example illustrates the benefit of tax deductibility.
8. The exclusion is 80% if the corporation owns between 20 and 80% of the stock in the corporation paying it dividends; 100% of the dividends received are excluded if it owns more than 80% of the corporation paying it dividends. For convenience, we are assuming here that the ownership interest in the dividend-paying corporation is less
than 20%.
CHAPTER 1
EXAMPLE
The Role and Environment of Managerial Finance
31
Two companies, Debt Co. and No Debt Co., both expect in the coming year to
have earnings before interest and taxes of $200,000. Debt Co. during the year
will have to pay $30,000 in interest. No Debt Co. has no debt and therefore will
have no interest expense. Calculation of the earnings after taxes for these two
firms is as follows:
Debt Co.
No Debt Co.
Earnings before interest and taxes
$200,000
$200,000
Less: Interest expense
30,000
$170,000
0
$200,000
68,000
$102,000
80,000
$120,000
Earnings before taxes
Less: Taxes (40%)
Earnings after taxes
Difference in earnings after taxes
$18,000
Whereas Debt Co. had $30,000 more interest expense than No Debt Co., Debt
Co.’s earnings after taxes are only $18,000 less than those of No Debt Co.
($102,000 for Debt Co. versus $120,000 for No Debt Co.). This difference is
attributable to the fact that Debt Co.’s $30,000 interest expense deduction provided a tax savings of $12,000 ($68,000 for Debt Co. versus $80,000 for No
Debt Co.). This amount can be calculated directly by multiplying the tax rate by
the amount of interest expense (0.40 $30,000 $12,000). Similarly, the
$18,000 after-tax cost of the interest expense can be calculated directly by multiplying one minus the tax rate by the amount of interest expense [(1 0.40) $30,000 $18,000].
The tax deductibility of certain expenses reduces their actual (after-tax) cost
to the profitable firm. Note that both for accounting and tax purposes interest is
a tax-deductible expense, whereas dividends are not. Because dividends are not
tax deductible, their after-tax cost is equal to the amount of the dividend. Thus a
$30,000 cash dividend has an after-tax cost of $30,000.
Capital Gains
capital gain
The amount by which the sale
price of an asset exceeds the
asset’s initial purchase price.
If a firm sells a capital asset (such as stock held as an investment) for more than
its initial purchase price, the difference between the sale price and the purchase
price is called a capital gain. For corporations, capital gains are added to ordinary
corporate income and taxed at the regular corporate rates, with a maximum marginal tax rate of 39 percent.9 To simplify the computations presented in the text,
as for ordinary income, a fixed 40 percent tax rate is assumed to be applicable to
corporate capital gains.
9. The Omnibus Budget Reconciliation Act of 1993 included a provision that allows the capital gains tax to be
halved on gains resulting from investments made after January 1, 1993, in startup firms with a value of less than $50
million that have been held for at least 5 years. This special provision, which is intended to help startup firms, is
ignored throughout this text.
32
PART 1
Introduction to Managerial Finance
EXAMPLE
Ross Company, a manufacturer of pharmaceuticals, has pretax operating earnings of $500,000 and has just sold for $40,000 an asset that was purchased 2
years ago for $36,000. Because the asset was sold for more than its initial purchase price, there is a capital gain of $4,000 ($40,000 sale price $36,000 initial
purchase price). The corporation’s taxable income will total $504,000 ($500,000
ordinary income plus $4,000 capital gain). Because this total is above $335,000,
the capital gain will be taxed at the 34% rate (see Table 1.4), resulting in a tax of
$1,360 (0.34 $4,000).
Tax Loss Carrybacks and Carryforwards
tax loss carryback/carryforward
A tax benefit that allows
corporations experiencing
operating losses to carry tax
losses back up to 2 years and
forward for as many as 20 years.
WW
W
Corporations that are experiencing operating losses may obtain tax relief by using a
tax loss carryback/carryforward. The tax laws allow corporations to carry tax
losses back up to 2 years and forward for as many as 20 years. This feature is especially attractive for firms in cyclic businesses such as durable goods manufacturing
and construction. It effectively allows them to average out their taxes over the good
and bad years. The law requires the net amount of losses to first be carried back,
applying them to the earliest year allowable, and progressively moving forward
until the loss has been fully recovered or the carryforward period has passed.
Because tax losses can be carried back and applied to previous pretax earnings as
soon as they are realized, the firm can apply for an immediate tax refund on its carrybacks. A carryforward, if any, can be used to reduce future income, thereby
reducing future tax payments. See the book’s Web site at www.aw.com/gitman for
an example of how tax loss carrybacks/carryforwards work.
Review Questions
1–26 Describe the tax treatment of ordinary income and that of capital gains. What
is the difference between the average tax rate and the marginal tax rate?
1–27 Why might the intercorporate dividend exclusion make corporate stock
investments by one corporation in another more attractive than bond
investments?
1–28 What benefit results from the tax deductibility of certain corporate
expenses?
1–29 How is the tax loss carryback/carryforward used when a firm experiences
an operating loss in a given year?
1.6 Using This Text
The organization of this textbook links the firm’s activities to its value, as determined in the securities markets. The activities of the financial manager are
described in the six parts of the book. Each major decision area is presented in
terms of both return and risk factors and their potential impact on owners’ wealth.
Coverage of international events and topics is integrated into the chapter discussions, and a separate chapter on international managerial finance is also included.
The text has been developed around a group of learning goals—six per chapter. Mastery of these goals results in a broad understanding of managerial
finance. These goals have been carefully integrated into a learning system. Each
CHAPTER 1
The Role and Environment of Managerial Finance
33
chapter begins with a numbered list of learning goals. Next to each major text
heading is a “toolbox,” which notes by number the specific learning goal(s)
addressed in that section. At the end of each section of the chapter (positioned
before the next major heading) are review questions that test your understanding
of the material in that section. At the end of each chapter, the chapter summaries,
self-test problems, and problems are also keyed by number to each chapter’s
learning goals. By linking all elements to the learning goals, the integrated learning system facilitates your mastery of the goals.
Also keyed to various parts of the text is the PMF CD-ROM Software, a disk
for use with IBM PCs and compatible microcomputers. The disk contains three
different sets of routines:
1. The PMF Tutor is a user-friendly program that extends self-testing opportunities in the more quantitative chapters beyond those included in the end-ofchapter materials. It gives immediate feedback with detailed solutions and
provides tutorial assistance (including text references). Text discussions and
end-of-chapter problems with which the PMF Tutor can be used are marked
with a
.
2. The PMF Problem-Solver can be used as an aid in performing many of the
routine financial calculations presented in the book. A disk symbol,
,
identifies those text discussions and end-of-chapter problems that can be
solved with the PMF Problem-Solver.
3. The PMF Excel Spreadsheet Templates can be used with Microsoft Excel to
input data and carry out “what-if” types of analyses in selected chapters.
These problems are marked by the symbol
.
A detailed discussion of how to use the PMF CD-ROM Software—the Tutor,
the Problem-Solver, and the Excel Spreadsheet Templates—is included in
Appendix D at the back of this book.
Each chapter ends with a case that integrates the chapter materials, and each
part ends with an integrative case that ties together the key topical material covered in the chapters within that part. Where applicable, the symbols for the PMF
Problem-Solver and/or the PMF Tutor identify case questions that can be solved
with the aid of these programs. Both the chapter-end and the part-end cases can
be used to synthesize and apply related concepts and techniques.
S U M M A RY
FOCUS ON VALUE
Chapter 1 established the primary goal of the firm—to maximize the wealth of the owners
for whom the firm is being operated. For public companies, which are the focus of this text,
value at any time is reflected in the stock price. Therefore, management should act only on
those alternatives or opportunities that are expected to create value for owners by increasing
the stock price. Doing this requires management to consider the returns (magnitude and timing of cash flows) and the risk of each proposed action and their combined impact on value.
34
PART 1
Introduction to Managerial Finance
REVIEW OF LEARNING GOALS
Define finance, the major areas of finance
and the career opportunities available in this
field and the legal forms of business organization.
Finance, the art and science of managing money,
affects the lives of every person and every organization. Major opportunities in financial services exist
within banking and related institutions, personal
financial planning, investments, real estate, and insurance. Managerial finance is concerned with the
duties of the financial manager in the business firm.
It offers numerous career opportunities, as shown in
Table 1.3. The recent trend toward globalization of
business activity has created new demands and opportunities in managerial finance.
The legal forms of business organization are the
sole proprietorship, the partnership, and the corporation. The corporation is dominant in terms of
business receipts and profits, and its owners are its
common and preferred stockholders. Stockholders
expect to earn a return by receiving dividends or by
realizing gains through increases in share price. The
key strengths and weaknesses of the common legal
forms of business organization are summarized in
Table 1.1. Other limited liability organizations are
listed and described in Table 1.2.
LG1
Describe the managerial finance function and
its relationship to economics and accounting.
All areas of responsibility within a firm interact
with finance personnel and procedures. In large
firms, the managerial finance function might be
handled by a separate department headed by the
vice president of finance (CFO), to whom the treasurer and controller report. The financial manager
must understand the economic environment and relies heavily on the economic principle of marginal
analysis to make financial decisions. Financial managers use accounting but concentrate on cash flows
and decision making.
LG2
Identify the primary activities of the financial
manager within the firm. The primary activities
of the financial manager, in addition to ongoing involvement in financial analysis and planning, are
making investment decisions and making financing
decisions.
LG3
LG4
Explain why wealth maximization, rather than
profit maximization, is the firm’s goal and how
the agency issue is related to it. The goal of the financial manager is to maximize the owners’ wealth,
as evidenced by stock price. Profit maximization ignores the timing of returns, does not directly consider cash flows, and ignores risk, so it is an inappropriate goal. Both return and risk must be
assessed by the financial manager who is evaluating
decision alternatives. The wealth-maximizing actions of financial managers should also reflect the
interests of stakeholders, groups who have a direct
economic link to the firm. Positive ethical practices
help the firm and its managers to achieve the firm’s
goal of owner wealth maximization.
An agency problem results when managers, as
agents for owners, place personal goals ahead of
corporate goals. Market forces, in the firm of shareholder activism and the threat of takeover, tend to
prevent or minimize agency problems. Firms incur
agency costs to monitor managers’ actions and provide incentives for them to act in the best interests
of owners. Stock options and performance plans are
examples of such agency costs.
Understand the relationship between financial
institutions and markets, and the role and
operations of the money and capital markets.
Financial institutions serve as intermediaries by
channeling into loans or investments the savings of
individuals, businesses, and governments. The
financial markets are forums in which suppliers and
demanders of funds can transact business directly.
Financial institutions actively participate in the
financial markets as both suppliers and demanders
of funds.
In the money market, marketable securities
(short-term debt instruments) are traded, typically
through large New York banks and government
securities dealers. The Eurocurrency market is the
international equivalent of the domestic money
market.
In the capital market, transactions in long-term
debt (bonds) and equity (common and preferred
stock) are made. The organized securities exchanges
provide secondary markets for securities. The overthe-counter exchange, a telecommunications network, offers a secondary market for securities and is
a primary market in which new public issues are
sold. Important debt and equity markets—the
Eurobond market and the international equity marLG5
CHAPTER 1
ket—exist outside of the United States. The securities exchanges create continuous liquid markets for
needed financing and allocate funds to their most
productive uses.
Discuss the fundamentals of business taxation
of ordinary income and capital gains, and explain the treatment of tax losses. Corporate income
is subject to corporate taxes. Corporate tax rates
LG6
SELF-TEST PROBLEMS
LG6
The Role and Environment of Managerial Finance
35
are applicable to both ordinary income (after deduction of allowable expenses) and capital gains. The
average tax rate paid by a corporation ranges from
15 to nearly 35 percent. (For convenience, we assume a 40 percent marginal tax rate in this book.)
Corporate taxpayers can reduce their taxes through
certain provisions in the tax code: intercorporate
dividend exclusions, tax-deductible expenses, and
tax loss carrybacks and carryforwards.
(Solutions in Appendix B)
ST 1–1
Corporate taxes Montgomery Enterprises, Inc., had operating earnings of
$280,000 for the year just ended. During the year the firm sold stock that it held
in another company for $180,000, which was $30,000 above its original purchase price of $150,000, paid 1 year earlier.
a. What is the amount, if any, of capital gains realized during the year?
b. How much total taxable income did the firm earn during the year?
c. Use the corporate tax rate schedule given in Table 1.4 to calculate the firm’s
total taxes due.
d. Calculate both the average tax rate and the marginal tax rate on the basis of
your findings.
LG1
1–1
Liability comparisons Merideth Harper has invested $25,000 in Southwest
Development Company. The firm has recently declared bankruptcy and has
$60,000 in unpaid debts. Explain the nature of payments, if any, by Ms. Harper
in each of the following situations.
a. Southwest Development Company is a sole proprietorship owned by Ms.
Harper.
b. Southwest Development Company is a 50–50 partnership of Ms. Harper and
Christopher Black.
c. Southwest Development Company is a corporation.
LG4
1–2
Marginal analysis and the goal of the firm Ken Allen, capital budgeting analyst
for Bally Gears, Inc., has been asked to evaluate a proposal. The manager of the
automotive division believes that replacing the robotics used on the heavy truck
gear line will produce total benefits of $560,000 (in today’s dollars) over the
next 5 years. The existing robotics would produce benefits of $400,000 (also in
today’s dollars) over that same time period. An initial cash investment of
$220,000 would be required to install the new equipment. The manager estimates that the existing robotics can be sold for $70,000. Show how Ken will
apply marginal analysis techniques to determine the following:
a. The marginal (added) benefits of the proposed new robotics.
b. The marginal (added) cost of the proposed new robotics.
c. The net benefit of the proposed new robotics.
d. What should Ken Allen recommend that the company do? Why?
e. What factors besides the costs and benefits should be considered before the
final decision is made?
PROBLEMS
LG2
36
PART 1
Introduction to Managerial Finance
LG2
1–3
Accrual income versus cash flow for a period Thomas Book Sales, Inc., supplies textbooks to college and university bookstores. The books are shipped with
a proviso that they must be paid for within 30 days but can be returned for a full
refund credit within 90 days. In 2003, Thomas shipped and billed book titles
totaling $760,000. Collections, net of return credits, during the year totaled
$690,000. The company spent $300,000 acquiring the books that it shipped.
a. Using accrual accounting and the preceding values, show the firm’s net profit
for the past year.
b. Using cash accounting and the preceding values, show the firm’s net cash
flow for the past year.
c. Which of these statements is more useful to the financial manager? Why?
LG4
1–4
Identifying agency problems, costs, and resolutions Explain why each of the
following situations is an agency problem and what costs to the firm might
result from it. Suggest how the problem might be dealt with short of firing the
individual(s) involved.
a. The front desk receptionist routinely takes an extra 20 minutes of lunch to
run personal errands.
b. Division managers are padding cost estimates in order to show short-term
efficiency gains when the costs come in lower than the estimates.
c. The firm’s chief executive officer has secret talks with a competitor about the
possibility of a merger in which (s)he would become the CEO of the combined firms.
d. A branch manager lays off experienced full-time employees and staffs customer service positions with part-time or temporary workers to lower
employment costs and raise this year’s branch profit. The manager’s bonus is
based on profitability.
LG6
1–5
Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusive distributor of a major line of sporting goods. During 2003 the firm earned
$92,500 before taxes.
a. Calculate the firm’s tax liability using the corporate tax rate schedule given in
Table 1.4.
b. How much are Tantor Supply’s 2003 after-tax earnings?
c. What was the firm’s average tax rate, based on your findings in part a?
d. What is the firm’s marginal tax rate, based on your findings in part a?
LG6
1–6
Average corporate tax rates Using the corporate tax rate schedule given in
Table 1.4, perform the following:
a. Calculate the tax liability, after-tax earnings, and average tax rates for the
following levels of corporate earnings before taxes: $10,000; $80,000;
$300,000; $500,000; $1.5 million; $10 million; and $15 million.
b. Plot the average tax rates (measured on the y axis) against the pretax income
levels (measured on the x axis). What generalization can be made concerning
the relationship between these variables?
LG6
1–7
Marginal corporate tax rates Using the corporate tax rate schedule given in
Table 1.4, perform the following:
a. Find the marginal tax rate for the following levels of corporate earnings
before taxes: $15,000; $60,000; $90,000; $200,000; $400,000; $1 million;
and $20 million.
CHAPTER 1
The Role and Environment of Managerial Finance
37
b. Plot the marginal tax rates (measured on the y axis) against the pretax
income levels (measured on the x axis). Explain the relationship between
these variables.
LG6
1–8
Interest versus dividend income During the year just ended, Shering
Distributors, Inc., had pretax earnings from operations of $490,000. In addition, during the year it received $20,000 in income from interest on bonds it
held in Zig Manufacturing and received $20,000 in income from dividends on
its 5% common stock holding in Tank Industries, Inc. Shering is in the 40%
tax bracket and is eligible for a 70% dividend exclusion on its Tank Industries
stock.
a. Calculate the firm’s tax on its operating earnings only.
b. Find the tax and the after-tax amount attributable to the interest income
from Zig Manufacturing bonds.
c. Find the tax and the after-tax amount attributable to the dividend income
from the Tank Industries, Inc., common stock.
d. Compare, contrast, and discuss the after-tax amounts resulting from the
interest income and dividend income calculated in parts b and c.
e. What is the firm’s total tax liability for the year?
LG6
1–9
Interest versus dividend expense Michaels Corporation expects earnings before
interest and taxes to be $40,000 for this period. Assuming an ordinary tax rate
of 40%, compute the firm’s earnings after taxes and earnings available for common stockholders (earnings after taxes and preferred stock dividends, if any)
under the following conditions:
a. The firm pays $10,000 in interest.
b. The firm pays $10,000 in preferred stock dividends.
LG6
1–10
Capital gains taxes Perkins Manufacturing is considering the sale of two nondepreciable assets, X and Y. Asset X was purchased for $2,000 and will be sold
today for $2,250. Asset Y was purchased for $30,000 and will be sold today for
$35,000. The firm is subject to a 40% tax rate on capital gains.
a. Calculate the amount of capital gain, if any, realized on each of the assets.
b. Calculate the tax on the sale of each asset.
LG6
1–11
Capital gains taxes The following table contains purchase and sale prices for
the nondepreciable capital assets of a major corporation. The firm paid taxes of
40% on capital gains.
Asset
Purchase price
Sale price
A
$ 3,000
$ 3,400
B
12,000
12,000
C
62,000
80,000
D
41,000
45,000
E
16,500
18,000
a. Determine the amount of capital gain realized on each of the five assets.
b. Calculate the amount of tax paid on each of the assets.
38
PART 1
Introduction to Managerial Finance
CHAPTER 1 CASE
Assessing the Goal of Sports Products, Inc.
L
oren Seguara and Dale Johnson both work for Sports Products, Inc., a major
producer of boating equipment and accessories. Loren works as a clerical
assistant in the Accounting Department, and Dale works as a packager in the
Shipping Department. During their lunch break one day, they began talking
about the company. Dale complained that he had always worked hard trying not
to waste packing materials and efficiently and cost-effectively performing his
job. In spite of his efforts and those of his co-workers in the department, the
firm’s stock price had declined nearly $2 per share over the past 9 months.
Loren indicated that she shared Dale’s frustration, particularly because the firm’s
profits had been rising. Neither could understand why the firm’s stock price was
falling as profits rose.
Loren indicated that she had seen documents describing the firm’s profitsharing plan under which all managers were partially compensated on the basis
of the firm’s profits. She suggested that maybe it was profit that was important
to management, because it directly affected their pay. Dale said, “That doesn’t
make sense, because the stockholders own the firm. Shouldn’t management do
what’s best for stockholders? Something’s wrong!” Loren responded, “Well,
maybe that explains why the company hasn’t concerned itself with the stock
price. Look, the only profits that stockholders receive are in the form of cash
dividends, and this firm has never paid dividends during its 20-year history. We
as stockholders therefore don’t directly benefit from profits. The only way we
benefit is for the stock price to rise.” Dale chimed in, “That probably explains
why the firm is being sued by state and federal environmental officials for dumping pollutants in the adjacent stream. Why spend money for pollution control? It
increases costs, lowers profits, and therefore lowers management’s earnings!”
Loren and Dale realized that the lunch break had ended and they must
quickly return to work. Before leaving, they decided to meet the next day to continue their discussion.
Required
a. What should the management of Sports Products, Inc., pursue as its overriding goal? Why?
b. Does the firm appear to have an agency problem? Explain.
c. Evaluate the firm’s approach to pollution control. Does it seem to be ethical?
Why might incurring the expense to control pollution be in the best interests
of the firm’s owners in spite of its negative impact on profits?
d. On the basis of the information provided, what specific recommendations
would you offer the firm?
WEB EXERCISE
WW
W
At the Careers in Finance Web site, www.careers-in-finance.com, you will find
information on career opportunities in seven different areas of finance. First
click on Corporate Finance in the Areas to Explore section and use the various
subsections to answer the following questions:
1. What are the primary responsibilities of the financial manager?
2. Summarize the types of skills a financial manager needs.
CHAPTER 1
The Role and Environment of Managerial Finance
39
3. Describe the key job areas in corporate finance.
4. What are the salary ranges for the following positions in corporate finance:
rookie financial analyst, credit manager, chief financial officer? How do
these compare to salaries at General Motors or PepsiCo?
Now return to the home page and click on either Commercial Banking or Investment Banking.
5. How do careers in the area you chose (commercial banking or investment
banking) compare to careers in corporate finance in terms of skills required,
responsibilities, and salaries?
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
CHAPTER
2
FINANCIAL
STATEMENTS
AND ANALYSIS
L E A R N I N G
LG1
Review the contents of the stockholders’ report
and the procedures for consolidating international
financial statements.
LG2
Understand who uses financial ratios, and
how.
LG3
Use ratios to analyze a firm’s liquidity and
activity.
LG4
LG5
LG6
G O A L S
Use ratios to analyze a firm’s profitability and its
market value.
Use a summary of financial ratios and the DuPont
system of analysis to perform a complete ratio
analysis.
Discuss the relationship between debt and
financial leverage and the ratios used to analyze
a firm’s debt.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand the stockholders’ report
and preparation of the four key financial statements; how firms
consolidate international financial statements; and how to calculate and interpret financial ratios for decision making.
Information systems: You need to understand what data are
included in the firm’s financial statements in order to design
systems that will supply such data to those who prepare the
statements and to those in the firm who use the data for ratio
calculations.
Management: You need to understand what parties are interested in the annual report and why; how the financial statements will be analyzed by those both inside and outside the firm
to assess various aspects of performance; the caution that
40
should be exercised in using financial ratio analysis; and how
the financial statements affect the value of the firm.
Marketing: You need to understand the effects your decisions
will have on the financial statements, particularly the income
statement and the statement of cash flows, and how analysis of
ratios, especially those involving sales figures, will affect the
firm’s decisions about levels of inventory, credit policies, and
pricing decisions.
Operations: You need to understand how the costs of operations are reflected in the firm’s financial statements and how
analysis of ratios, particularly those involving assets, cost of
goods sold, or inventory, may affect requests for new equipment or facilities.
HOME DEPOT
BUILDING STRONG
FINANCIALS
inancial reporting is no longer the primary responsibility of the chief financial officer (CFO). The
role of today’s CFO, a key member of the executive team, has broadened to include strategic
planning and, at many companies, information management. Managing a company’s financial
operations takes many different skills. Financial planning, operations, and analysis; treasury operations (raising funds and managing cash); business acquisition and valuation; tax planning; and
investor relations are also under his or her control.
Home Depot CFO and treasurer Carol Tomé reports directly to chief executive officer Robert
L. Nardelli. She works closely with him and with Dennis J. Carey, an executive vice president and
the chief strategy officer, to guide the giant home improvement retailer’s future growth. Along
with her strategic responsibilities, Tomé chooses the key financial measurements on which she
wants managers to focus. These are tied to the economic climate. When the economy was
strong, her objective was improving the company’s return on investment (ROI). By late 2001, Home
Depot’s ROI was 16.0 percent, compared to 14.7 percent for the home improvement retail industry,
6.7 percent for the services sector, and 10.2 percent for the S&P 500.
In 2001’s slower economy, the emphasis shifted to activity ratios that measure how quickly
accounts are converted into cash. Particularly important to a retail chain are inventory turnover,
receivables collection period, and accounts payable periods. Home Depot hired consultants to
benchmark its financial operations with other best-in-class companies. “We’re looking for processing efficiencies,” Tomé says. Improved new-store productivity and lower pre-opening costs
per store, together with attention to cost control, are boosting margins. In the third quarter of
2001, when many companies reported earnings drops, Home Depot’s net income and earnings per
share rose over the same period in 2000.
The company’s measures of debt also indicate a strong financial position. Its ratio of debt to
total capital indicates that only about 10 percent of its total long-term financing is debt, a very low
degree of indebtedness. This strong position gives Home Depot more flexibility to pursue new
projects, such as its new high-end line of stores called Expo, and more opportunities to raise
funds from banks, which use ratio analysis to assess creditworthiness.
In this chapter you will learn how to analyze financial statements using financial ratios.
F
41
42
PART 1
Introduction to Managerial Finance
LG1
2.1 The Stockholders’ Report
generally accepted
accounting principles (GAAP)
The practice and procedure
guidelines used to prepare and
maintain financial records and
reports; authorized by the
Financial Accounting Standards
Board (FASB).
Financial Accounting
Standards Board (FASB)
The accounting profession’s
rule-setting body, which
authorizes generally accepted
accounting principles (GAAP).
Securities and Exchange
Commission (SEC)
The federal regulatory body that
governs the sale and listing of
securities.
Every corporation has many and varied uses for the standardized records and
reports of its financial activities. Periodically, reports must be prepared for regulators, creditors (lenders), owners, and management. The guidelines used to prepare and maintain financial records and reports are known as generally accepted
accounting principles (GAAP). These accounting practices and procedures are
authorized by the accounting profession’s rule-setting body, the Financial
Accounting Standards Board (FASB).
Publicly owned corporations with more than $5 million in assets and 500 or
more stockholders1 are required by the Securities and Exchange Commission
(SEC)—the federal regulatory body that governs the sale and listing of securities—to provide their stockholders with an annual stockholders’ report. The
annual report summarizes and documents the firm’s financial activities during the
past year. It begins with a letter to the stockholders from the firm’s president
and/or chairman of the board.
The Letter to Stockholders
stockholders’ report
Annual report that publicly
owned corporations must provide
to stockholders; it summarizes
and documents the firm’s
financial activities during the
past year.
WW
W
The letter to stockholders is the primary communication from management. It
describes the events that are considered to have had the greatest impact on the
firm during the year. It also generally discusses management philosophy, strategies, and actions, as well as plans for the coming year. Links at this book’s
Web site (www.aw.com/gitman) will take you to some representative letters to
stockholders.
letter to stockholders
Typically, the first element of the
annual stockholders’ report and
the primary communication from
management.
The Four Key Financial Statements
The four key financial statements required by the SEC for reporting to shareholders are (1) the income statement, (2) the balance sheet, (3) the statement of
retained earnings, and (4) the statement of cash flows.2 The financial statements
from the 2003 stockholders’ report of Bartlett Company, a manufacturer of
metal fasteners, are presented and briefly discussed.
Income Statement
income statement
Provides a financial summary of
the firm’s operating results
during a specified period.
The income statement provides a financial summary of the firm’s operating results
during a specified period. Most common are income statements covering a 1-year
period ending at a specified date, ordinarily December 31 of the calendar year.
1. Although the Securities and Exchange Commission (SEC) does not have an official definition of publicly owned,
these financial measures mark the cutoff point it uses to require informational reporting, regardless of whether the
firm publicly sells its securities. Firms that do not meet these requirements are commonly called “closely owned”
firms.
2. Whereas these statement titles are consistently used throughout this text, it is important to recognize that in practice, companies frequently use different titles. For example, General Electric uses “Statement of Earnings” rather
than “Income Statement” and “Statement of Financial Position” rather than “Balance Sheet.” Bristol Myers Squibb
uses “Statement of Earnings and Retained Earnings” rather than “Income Statement.” Pfizer uses “Statement of
Shareholders’ Equity” rather than “Statement of Retained Earnings.”
CHAPTER 2
Hint Some firms, such as
retailers and agricultural firms,
end their fiscal year at the end
of their operating cycle rather
than at the end of the calendar
year—for example, retailers at
the end of January and
agricultural firms at the end of
September.
Financial Statements and Analysis
43
Many large firms, however, operate on a 12-month financial cycle, or fiscal year,
that ends at a time other than December 31. In addition, monthly income statements are typically prepared for use by management, and quarterly statements
must be made available to the stockholders of publicly owned corporations.
Table 2.1 presents Bartlett Company’s income statements for the years ended
December 31, 2003 and 2002. The 2003 statement begins with sales revenue—
the total dollar amount of sales during the period—from which the cost of goods
sold is deducted. The resulting gross profits of $986,000 represent the amount
remaining to satisfy operating, financial, and tax costs. Next, operating expenses,
which include selling expense, general and administrative expense, lease expense,
TABLE 2.1
Bartlett Company Income
Statements ($000)
For the years ended
December 31
2003
2002
Sales revenue
$3,074
$2,567
Less: Cost of goods sold
2
,0
8
8
$ 986
1
,7
1
1
$ 856
$ 100
$ 108
194
187
Gross profits
Less: Operating expenses
Selling expense
General and administrative expenses
Lease expensea
35
35
2
3
9
$ 568
$ 418
2
2
3
$ 553
$ 303
9
3
$ 325
9
1
$ 212
9
4
$ 231
6
4
$ 148
Earnings available for common stockholders
1
0
$
2
2
1
1
0
$
1
3
8
Earnings per share (EPS)c
$ 2.90
$ 1.81
Dividend per share (DPS)d
$ 1.29
$ 0.75
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate 29%)b
Net profits after taxes
Less: Preferred stock dividends
aLease
expense is shown here as a separate item rather than being included as
part of interest expense, as specified by the FASB for financial-reporting purposes. The approach used here is consistent with tax-reporting rather than
financial-reporting procedures.
bThe 29% tax rate for 2003 results because the firm has certain special tax
write-offs that do not show up directly on its income statement.
cCalculated by dividing the earnings available for common stockholders by
the number of shares of common stock outstanding—76,262 in 2003 and
76,244 in 2002. Earnings per share in 2003: $221,000 76,262 $2.90; in
2002: $138,000 76,244 $1.81.
dCalculated by dividing the dollar amount of dividends paid to common stockholders by the number of shares of common stock outstanding. Dividends per
share in 2003: $98,000 76,262 $1.29; in 2002: $57,183 76,244 $0.75.
44
PART 1
Introduction to Managerial Finance
dividend per share (DPS)
The dollar amount of cash
distributed during the period on
behalf of each outstanding share
of common stock.
and depreciation expense, are deducted from gross profits.3 The resulting operating profits of $418,000 represent the profits earned from producing and selling
products; this amount does not consider financial and tax costs. (Operating
profit is often called earnings before interest and taxes, or EBIT.) Next, the financial cost—interest expense—is subtracted from operating profits to find net profits (or earnings) before taxes. After subtracting $93,000 in 2003 interest, Bartlett
Company had $325,000 of net profits before taxes.
Next, taxes are calculated at the appropriate tax rates and deducted to determine net profits (or earnings) after taxes. Bartlett Company’s net profits after
taxes for 2003 were $231,000. Any preferred stock dividends must be subtracted
from net profits after taxes to arrive at earnings available for common stockholders. This is the amount earned by the firm on behalf of the common stockholders
during the period.
Dividing earnings available for common stockholders by the number of
shares of common stock outstanding results in earnings per share (EPS). EPS represents the number of dollars earned during the period on behalf of each outstanding share of common stock. In 2003, Bartlett Company earned $221,000
for its common stockholders, which represents $2.90 for each outstanding share.
The actual cash dividend per share (DPS), which is the dollar amount of cash distributed during the period on behalf of each outstanding share of common stock,
paid in 2003 was $1.29.
Balance Sheet
balance sheet
Summary statement of the firm’s
financial position at a given point
in time.
current assets
Short-term assets, expected to
be converted into cash within 1
year or less.
current liabilities
Short-term liabilities, expected
to be paid within 1 year or less.
The balance sheet presents a summary statement of the firm’s financial position
at a given point in time. The statement balances the firm’s assets (what it owns)
against its financing, which can be either debt (what it owes) or equity (what was
provided by owners). Bartlett Company’s balance sheets as of December 31 of
2003 and 2002 are presented in Table 2.2. They show a variety of asset, liability
(debt), and equity accounts.
An important distinction is made between short-term and long-term assets
and liabilities. The current assets and current liabilities are short-term assets and
liabilities. This means that they are expected to be converted into cash (current
assets) or paid (current liabilities) within 1 year or less. All other assets and liabilities, along with stockholders’ equity, which is assumed to have an infinite life,
are considered long-term, or fixed, because they are expected to remain on the
firm’s books for more than 1 year.
As is customary, the assets are listed from the most liquid—cash—down to
the least liquid. Marketable securities are very liquid short-term investments, such
as U.S. Treasury bills or certificates of deposit, held by the firm. Because they are
highly liquid, marketable securities are viewed as a form of cash (“near cash”).
Accounts receivable represent the total monies owed the firm by its customers on
credit sales made to them. Inventories include raw materials, work in process
(partially finished goods), and finished goods held by the firm. The entry for
gross fixed assets is the original cost of all fixed (long-term) assets owned by the
3. Depreciation expense can be, and frequently is, included in manufacturing costs—cost of goods sold—to calculate
gross profits. Depreciation is shown as an expense in this text to isolate its impact on cash flows.
CHAPTER 2
TABLE 2.2
Financial Statements and Analysis
Bartlett Company Balance Sheets ($000)
December 31
Assets
2003
2002
$ 363
$ 288
68
51
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets (at cost)a
Land and buildings
Machinery and equipment
503
365
289
$1,223
300
$1,004
$2,072
$1,903
1,866
1,693
Furniture and fixtures
358
316
Vehicles
275
314
98
$4,669
96
$4,322
2,295
$2,374
$3,597
2,056
$2,266
$3,270
$ 382
$ 270
79
99
1
5
9
$
6
2
0
$
1
,0
2
3
1
1
4
$
4
8
3
$
9
6
7
$1,643
$1,450
$ 200
$ 200
Other (includes financial leases)
Total gross fixed assets (at cost)
Less: Accumulated depreciation
Net fixed assets
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt (includes financial leases)b
Total liabilities
Stockholders’ equity
Preferred stock—cumulative 5%, $100 par, 2,000 shares
authorized and issuedc
Common stock—$2.50 par, 100,000 shares authorized, shares
issued and outstanding in 2003: 76,262; in 2002: 76,244
191
190
Paid-in capital in excess of par on common stock
428
418
1,135
$1,954
$3,597
1,012
$1,820
$3,270
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
aIn
2003, the firm has a 6-year financial lease requiring annual beginning-of-year payments of $35,000.
Four years of the lease have yet to run.
bAnnual principal repayments on a portion of the firm’s total outstanding debt amount to $71,000.
cThe annual preferred stock dividend would be $5 per share (5% $100 par), or a total of $10,000
annually ($5 per share 2,000 shares).
45
46
PART 1
Introduction to Managerial Finance
FOCUS ON PRACTICE
Extraordinary? Not to the FASB!
To most of us, the events of September 11, 2001, would certainly
qualify as extraordinary. The plane
crashes that took thousands of
lives, destroyed the World Trade
Center Towers, and damaged part
of the Pentagon were circumstances well outside what we
consider “ordinary.” Yet, several
weeks after the tragedy the
Financial Accounting Standards
Board (FASB) announced that the
terrorist attack did not constitute
an extraordinary event—at least
not in accounting terms.
As a result, companies will
not be able to separate costs and
expenses related to the disaster as
extraordinary on their financial
statements. Those expenses will
show up as normal operating costs
in the continuing operations section of the income statement.
Hint Another interpretation
of the balance sheet is that on
one side are the assets that have
been purchased to be used to
increase the profit of the firm.
The other side indicates how
these assets were acquired,
either by borrowing or by
investing the owner’s money.
long-term debt
Debts for which payment is not
due in the current year.
paid-in capital in excess of par
The amount of proceeds in
excess of the par value received
from the original sale of common
stock.
Explained Tim Lucas, chair of the
FASB Emerging Issues Task Force,
“The task force understood that
this was an extraordinary event in
the English-language sense of the
word. But in the final analysis, we
decided it wasn’t going to improve
the financial reporting system to
show it [separately].”
The FASB task force had prepared a draft document with
guidelines on accounting for disaster-related costs as extraordinary. As they considered how to
apply these recommendations,
they realized that the impact of the
attack was so far-ranging that it
was almost impossible to divide direct financial and economic effects from the weakening economic conditions prior to
September 11. Nor was it possible
to develop one set of guidelines
In Practice
appropriate for all industries. FASB
members were concerned that
companies would blame negative
financial performance on the attacks when in fact the costs were
unrelated. As one member pointed
out, almost every company was affected in some way. Because the
whole business climate changed,
“it almost made it ordinary.”
Companies will, however, be
able to separate costs they believe
to be attributable to September 11
in the footnotes to financial statements and in management’s discussion of financial results.
Sources: Jennifer Davies, “Will Attacks
Cover Up Weak Earnings?” San Diego
Union-Tribune (October 14, 2001), pp. H1, H6;
Steve Liesman, “Accountants, in a Reversal,
Say Costs from the Attack Aren’t ‘Extraordinary,’” Wall Street Journal (October 1, 2001),
pp. C1-2; Keith Naughton, “Out of the Ordinary,” Newsweek (October 15, 2001), p. 9.
firm.4 Net fixed assets represent the difference between gross fixed assets and
accumulated depreciation—the total expense recorded for the depreciation of
fixed assets. (The net value of fixed assets is called their book value.)
Like assets, the liabilities and equity accounts are listed from short-term to
long-term. Current liabilities include accounts payable, amounts owed for credit
purchases by the firm; notes payable, outstanding short-term loans, typically
from commercial banks; and accruals, amounts owed for services for which a bill
may not or will not be received. (Examples of accruals include taxes due the government and wages due employees.) Long-term debt represents debt for which
payment is not due in the current year. Stockholders’ equity represents the owners’ claims on the firm. The preferred stock entry shows the historical proceeds
from the sale of preferred stock ($200,000 for Bartlett Company).
Next, the amount paid by the original purchasers of common stock is shown
by two entries: common stock and paid-in capital in excess of par on common
stock. The common stock entry is the par value of common stock. Paid-in capital
in excess of par represents the amount of proceeds in excess of the par value
received from the original sale of common stock. The sum of the common stock
4. For convenience the term fixed assets is used throughout this text to refer to what, in a strict accounting sense, is
captioned “property, plant, and equipment.” This simplification of terminology permits certain financial concepts
to be more easily developed.
CHAPTER 2
retained earnings
The cumulative total of all
earnings, net of dividends, that
have been retained and
reinvested in the firm since its
inception.
Financial Statements and Analysis
47
and paid-in capital accounts divided by the number of shares outstanding represents the original price per share received by the firm on a single issue of common
stock. Bartlett Company therefore received about $8.12 per share [($191,000
par $428,000 paid-in capital in excess of par) 76,262 shares] from the sale of
its common stock.
Finally, retained earnings represent the cumulative total of all earnings, net of
dividends, that have been retained and reinvested in the firm since its inception. It
is important to recognize that retained earnings are not cash but rather have been
utilized to finance the firm’s assets.
Bartlett Company’s balance sheets in Table 2.2 show that the firm’s total
assets increased from $3,270,000 in 2002 to $3,597,000 in 2003. The $327,000
increase was due primarily to the $219,000 increase in current assets. The asset
increase in turn appears to have been financed primarily by an increase of
$193,000 in total liabilities. Better insight into these changes can be derived from
the statement of cash flows, which we will discuss shortly.
Statement of Retained Earnings
statement of retained earnings
Reconciles the net income
earned during a given year, and
any cash dividends paid, with the
change in retained earnings
between the start and the end of
that year.
The statement of retained earnings reconciles the net income earned during a
given year, and any cash dividends paid, with the change in retained earnings
between the start and the end of that year. Table 2.3 presents this statement for
Bartlett Company for the year ended December 31, 2003. The statement shows
that the company began the year with $1,012,000 in retained earnings and had
net profits after taxes of $231,000, from which it paid a total of $108,000 in dividends, resulting in year-end retained earnings of $1,135,000. Thus the net
increase for Bartlett Company was $123,000 ($231,000 net profits after taxes
minus $108,000 in dividends) during 2003.
Statement of Cash Flows
statement of cash flows
Provides a summary of the firm’s
operating, investment, and
financing cash flows and
reconciles them with changes in
its cash and marketable securities during the period.
The statement of cash flows is a summary of the cash flows over the period of
concern. The statement provides insight into the firm’s operating, investment,
and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. Bartlett Company’s statement of cash flows
for the year ended December 31, 2003, is presented in Table 2.4. Further insight
into this statement is included in the discussion of cash flow of in Chapter 3.
TABLE 2.3
Bartlett Company Statement of Retained
Earnings ($000) for the Year Ended
December 31, 2003
Retained earnings balance (January 1, 2003)
$1,012
Plus: Net profits after taxes (for 2003)
231
Less: Cash dividends (paid during 2003)
Preferred stock
($10)
Common stock
( 98)
Total dividends paid
Retained earnings balance (December 31, 2003)
( 108)
$1,135
48
PART 1
Introduction to Managerial Finance
TABLE 2.4
Bartlett Company Statement of Cash
Flows ($000) for the Year Ended
December 31, 2003
Cash Flow from Operating Activities
Net profits after taxes
$231
Depreciation
239
Increase in accounts receivable
Decrease in inventories
( 138)a
11
Increase in accounts payable
Increase in accruals
Cash provided by operating activities
112
45
$500
Cash Flow from Investment Activities
Increase in gross fixed assets
($347)
Change in business interests
0
Cash provided by investment activities
( 347)
Cash Flow from Financing Activities
Decrease in notes payable
Increase in long-term debts
Changes in stockholders’
equityb
Dividends paid
Cash provided by financing activities
($ 20)
56
11
( 108)
Net increase in cash and marketable securities
( 61)
$ 92
aAs
is customary, parentheses are used to denote a negative number, which in this case is a
cash outflow.
bRetained earnings are excluded here, because their change is actually reflected in the
combination of the “net profits after taxes” and “dividends paid” entries.
Notes to the Financial Statements
notes to the financial statements
Footnotes detailing information
on the accounting policies,
procedures, calculations, and
transactions underlying entries
in the financial statements.
Included with published financial statements are explanatory notes keyed to the
relevant accounts in the statements. These notes to the financial statements provide detailed information on the accounting policies, procedures, calculations,
and transactions underlying entries in the financial statements. Common issues
addressed by these notes include revenue recognition, income taxes, breakdowns
of fixed asset accounts, debt and lease terms, and contingencies. Professional
securities analysts use the data in the statements and notes to develop estimates of
the value of securities that the firm issues, and these estimates influence the
actions of investors and therefore the firm’s share value.
Consolidating International Financial Statements
So far, we’ve discussed financial statements involving only one currency, the U.S.
dollar. The issue of how to consolidate a company’s foreign and domestic financial statements has bedeviled the accounting profession for many years. The cur-
CHAPTER 2
Financial Accounting Standards
Board (FASB) Standard No. 52
Mandates that U.S.-based
companies translate their
foreign-currency-denominated
assets and liabilities into dollars,
for consolidation with the parent
company’s financial statements.
This is done by using the current
rate (translation) method.
WW
W
current rate (translation) method
Technique used by U.S.-based
companies to translate their
foreign-currency-denominated
assets and liabilities into dollars,
for consolidation with the parent
company’s financial statements,
using the exchange rate prevailing at the fiscal year ending date
(the current rate).
LG2
Financial Statements and Analysis
49
rent policy is described in Financial Accounting Standards Board (FASB) Standard No. 52, which mandates that U.S.-based companies translate their foreigncurrency-denominated assets and liabilities into dollars, for consolidation with
the parent company’s financial statements. This is done by using a technique
called the current rate (translation) method, under which all of a U.S. parent
company’s foreign-currency-denominated assets and liabilities are converted into
dollar values using the exchange rate prevailing at the fiscal year ending date (the
current rate). Income statement items are treated similarly. Equity accounts, on
the other hand, are translated into dollars by using the exchange rate that prevailed when the parent’s equity investment was made (the historical rate).
Retained earnings are adjusted to reflect each year’s operating profits or losses.
Further details on this procedure can be found at the book’s Web site at
www.aw.com/gitman or in an intermediate accounting text.
Review Questions
2–1
2–2
2–3
Describe the purpose of each of the four major financial statements.
Why are the notes to the financial statements important to professional
securities analysts?
How is the current rate (translation) method used to consolidate a firm’s
foreign and domestic financial statements?
2.2 Using Financial Ratios
ratio analysis
Involves methods of calculating
and interpreting financial ratios
to analyze and monitor the firm’s
performance.
The information contained in the four basic financial statements is of major significance to various interested parties who regularly need to have relative measures of the company’s operating efficiency. Relative is the key word here,
because the analysis of financial statements is based on the use of ratios or relative values. Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance. The basic inputs to
ratio analysis are the firm’s income statement and balance sheet.
Interested Parties
Hint Management should
be the most interested party of
this group. Managers not only
have to worry abut the
financial situation of the firm,
but they are also critically
interested in what the other
parties think about the firm.
Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors, and the firm’s own management. Both present and prospective shareholders
are interested in the firm’s current and future level of risk and return, which
directly affect share price. The firm’s creditors are interested primarily in the
short-term liquidity of the company and its ability to make interest and principal
payments. A secondary concern of creditors is the firm’s profitability; they want
assurance that the business is healthy. Management, like stockholders, is concerned with all aspects of the firm’s financial situation, and it attempts to produce
financial ratios that will be considered favorable by both owners and creditors. In
addition, management uses ratios to monitor the firm’s performance from period
to period.
50
PART 1
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Types of Ratio Comparisons
Ratio analysis is not merely the calculation of a given ratio. More important is
the interpretation of the ratio value. A meaningful basis for comparison is needed
to answer such questions as “Is it too high or too low?” and “Is it good or bad?”
Two types of ratio comparisons can be made: cross-sectional and time-series.
Cross-Sectional Analysis
cross-sectional analysis
Comparison of different firms’
financial ratios at the same point
in time; involves comparing the
firm’s ratios to those of other
firms in its industry or to industry
averages.
benchmarking
A type of cross-sectional
analysis in which the firm’s ratio
values are compared to those of
a key competitor or group of
competitors that it wishes to
emulate.
Hint Industry averages are
not particularly useful for
analyzing firms with
multiproduct lines. In the case
of multiproduct firms, it is
difficult to select the
appropriate benchmark
industry.
EXAMPLE
Cross-sectional analysis involves the comparison of different firms’ financial
ratios at the same point in time. Analysts are often interested in how well a firm
has performed in relation to other firms in its industry. Frequently, a firm will
compare its ratio values to those of a key competitor or group of competitors that
it wishes to emulate. This type of cross-sectional analysis, called benchmarking,
has become very popular.
Comparison to industry averages is also popular. These figures can be found
in the Almanac of Business and Industrial Financial Ratios, Dun & Bradstreet’s
Industry Norms and Key Business Ratios, Business Month, FTC Quarterly
Reports, Robert Morris Associates Statement Studies, Value Line, and industry
sources.5 A sample from one available source of industry averages is given in
Table 2.5.
Many people mistakenly believe that as long as the firm being analyzed has a
value “better than” the industry average, it can be viewed favorably. However,
this “better than average” viewpoint can be misleading. Quite often a ratio value
that is far better than the norm can indicate problems that, on more careful
analysis, may be more severe than had the ratio been worse than the industry
average. It is therefore important to investigate significant deviations to either
side of the industry standard.
In early 2004, Mary Boyle, the chief financial analyst at Caldwell Manufacturing,
a producer of heat exchangers, gathered data on the firm’s financial performance
during 2003, the year just ended. She calculated a variety of ratios and obtained
industry averages. She was especially interested in inventory turnover, which
reflects the speed with which the firm moves its inventory from raw materials
through production into finished goods and to the customer as a completed sale.
Generally, higher values of this ratio are preferred, because they indicate a
quicker turnover of inventory. Caldwell Manufacturing’s calculated inventory
turnover for 2003 and the industry average inventory turnover were as follows:
Inventory turnover, 2003
Caldwell Manufacturing
Industry average
14.8
9.7
5. Cross-sectional comparisons of firms operating in several lines of business are difficult to perform. The use of
weighted-average industry average ratios based on the firm’s product-line mix or, if data are available, analysis of
the firm on a product-line basis can be performed to evaluate a multiproduct firm.
CHAPTER 2
TABLE 2.5
Line of business
(number of
concerns
reporting)b
51
Financial Statements and Analysis
Industry Average Ratios (2001) for Selected Lines of Businessa
Total
liabilities
to net
worth
(%)
Current
ratio
(X)
Quick
ratio
(X)
Sales to
inventory
(X)
Collection
period
(days)
Total
assets
to sales
(%)
Return
on total
assets
(%)
Return
on net
worth
(%)
Department
6.2
1.9
6.0
2.9
34.3
19.7
stores
3.0
0.8
4.7
8.0
50.9
62.0
4.0
8.5
14.6
1.8
3.3
(167)
1.9
0.3
3.3
34.7
68.2
164.9
6.5
0.6
0.9
2.0
Electronic
3.6
1.8
19.0
34.7
36.4
computers
1.8
1.0
9.1
55.9
59.7
121.4
7.1
11.7
23.9
230.4
1.8
3.5
(91)
1.3
0.6
5.3
85.4
102.3
9.8
428.4
(0.8)
(3.1)
2.0
Grocery
2.5
0.9
31.0
1.1
stores
1.5
0.4
19.7
2.9
14.4
46.2
2.2
9.9
24.3
20.3
128.4
0.8
3.9
(541)
1.0
0.2
14.0
11.1
5.8
31.3
294.2
0.3
1.0
3.8
Motor
2.0
1.0
vehicles
1.5
0.7
11.2
18.5
27.9
95.9
3.7
9.7
24.1
8.7
26.7
39.0
174.3
1.9
3.7
(38)
1.2
0.3
15.6
5.8
47.5
59.2
393.9
0.6
1.4
3.4
Return
on sales
(%)
aThese values are given for each ratio for each line of business. The center value is the median, and the values immediately above and below it are
the upper and lower quartiles, respectively.
bStandard Industrial Classification (SIC) codes for the lines of business shown are, respectively: SIC #5311, SIC #3571, SIC #5411, SIC #3711.
Source: “Industry Norms and Key Business Ratios,” Copyright © 2001 Dun & Bradstreet, Inc. Reprinted with permission.
Mary’s initial reaction to these data was that the firm had managed its inventory significantly better than the average firm in the industry. The turnover was
nearly 53% faster than the industry average. Upon reflection, however, she realized that a very high inventory turnover could also mean very low levels of inventory. The consequence of low inventory could be excessive stockouts (insufficient
inventory). Discussions with people in the manufacturing and marketing departments did in fact uncover such a problem: Inventories during the year were
extremely low, the result of numerous production delays that hindered the firm’s
ability to meet demand and resulted in lost sales. What had initially appeared to
reflect extremely efficient inventory management was actually the symptom of a
major problem.
Time-Series Analysis
time-series analysis
Evaluation of the firm’s financial
performance over time using
financial ratio analysis.
Time-series analysis evaluates performance over time. Comparison of current to
past performance, using ratios, enables analysts to assess the firm’s progress.
Developing trends can be seen by using multiyear comparisons. As in crosssectional analysis, any significant year-to-year changes may be symptomatic of a
major problem.
52
PART 1
Introduction to Managerial Finance
Combined Analysis
The most informative approach to ratio analysis combines cross-sectional and
time-series analyses. A combined view makes it possible to assess the trend in the
behavior of the ratio in relation to the trend for the industry. Figure 2.1 depicts
this type of approach using the average collection period ratio of Bartlett Company, over the years 2000–2003. This ratio reflects the average amount of time it
takes the firm to collect bills, and lower values of this ratio generally are preferred.
The figure quickly discloses that (1) Bartlett’s effectiveness in collecting its receivables is poor in comparison to the industry, and (2) Bartlett’s trend is toward
longer collection periods. Clearly, Bartlett needs to shorten its collection period.
Cautions About Using Ratio Analysis
Before discussing specific ratios, we should consider the following cautions about
their use:
FIGURE 2.1
Combined Analysis
Combined cross-sectional
and time-series view of
Bartlett Company’s average
collection period, 2000–2003
Average Collection Period (days)
1. Ratios with large deviations from the norm only indicate symptoms of a
problem. Additional analysis is typically needed to isolate the causes of the
problem. The fundamental point is this: Ratio analysis merely directs attention to potential areas of concern; it does not provide conclusive evidence as
to the existence of a problem.
2. A single ratio does not generally provide sufficient information from which
to judge the overall performance of the firm. Only when a group of ratios is
used can reasonable judgments be made. However, if an analysis is concerned only with certain specific aspects of a firm’s financial position, one or
two ratios may be sufficient.
3. The ratios being compared should be calculated using financial statements
dated at the same point in time during the year. If they are not, the effects of
70
60
Bartlett
50
Industry
40
30
2000
2001
2002
Year
2003
CHAPTER 2
Financial Statements and Analysis
53
seasonality may produce erroneous conclusions and decisions. For example,
comparison of the inventory turnover of a toy manufacturer at the end of
June with its end-of-December value can be misleading. Clearly, the seasonal
impact of the December holiday selling season would skew any comparison
of the firm’s inventory management.
4. It is preferable to use audited financial statements for ratio analysis. If the
statements have not been audited, the data contained in them may not reflect
the firm’s true financial condition.
5. The financial data being compared should have been developed in the same
way. The use of differing accounting treatments—especially relative to inventory and depreciation—can distort the results of ratio analysis, regardless of
whether cross-sectional or time-series analysis is used.
6. Results can be distorted by inflation, which can cause the book values of
inventory and depreciable assets to differ greatly from their true (replacement) values. Additionally, inventory costs and depreciation write-offs can
differ from their true values, thereby distorting profits. Without adjustment,
inflation tends to cause older firms (older assets) to appear more efficient and
profitable than newer firms (newer assets). Clearly, in using ratios, care must
be taken to compare older to newer firms or a firm to itself over a long period
of time.
Categories of Financial Ratios
Financial ratios can be divided for convenience into five basic categories: liquidity, activity, debt, profitability, and market ratios. Liquidity, activity, and debt
ratios primarily measure risk. Profitability ratios measure return. Market ratios
capture both risk and return.
As a rule, the inputs necessary to an effective financial analysis include, at a
minimum, the income statement and the balance sheet. We will use the 2003 and
2002 income statements and balance sheets for Bartlett Company, presented earlier in Tables 2.1 and 2.2, to demonstrate ratio calculations. Note, however, that
the ratios presented in the remainder of this chapter can be applied to almost any
company. Of course, many companies in different industries use ratios that focus
on aspects peculiar to their industry.
Review Questions
2–4
2–5
2–6
2–7
With regard to financial ratio analysis, how do the viewpoints held by the
firm’s present and prospective shareholders, creditors, and management
differ?
What is the difference between cross-sectional and time-series ratio analysis? What is benchmarking?
What types of deviations from the norm should the analyst pay primary
attention to when performing cross-sectional ratio analysis? Why?
Why is it preferable to compare ratios calculated using financial statements that are dated at the same point in time during the year?
54
PART 1
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LG3
2.3 Liquidity Ratios
liquidity
A firm’s ability to satisfy its
short-term obligations as they
come due.
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come due. Liquidity refers to the solvency of the firm’s overall financial position—the ease with which it can pay its bills. Because a common precursor to financial distress and bankruptcy is low or declining liquidity, these ratios
are viewed as good leading indicators of cash flow problems. The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.
Current Ratio
current ratio
A measure of liquidity calculated
by dividing the firm’s current
assets by its current liabilities.
The current ratio, one of the most commonly cited financial ratios, measures the
firm’s ability to meet its short-term obligations. It is expressed as follows:
Current assets
Current ratio Current liabilities
The current ratio for Bartlett Company in 2003 is
$1,223,000
1.97
$620,000
Generally, the higher the current ratio, the more liquid the firm is considered
to be. A current ratio of 2.0 is occasionally cited as acceptable, but a value’s
acceptability depends on the industry in which the firm operates. For example, a
current ratio of 1.0 would be considered acceptable for a public utility but might
be unacceptable for a manufacturing firm. The more predictable a firm’s cash
flows, the lower the acceptable current ratio. Because Bartlett Company is in a
business with a relatively predictable annual cash flow, its current ratio of 1.97
should be quite acceptable.
Quick (Acid-Test) Ratio
quick (acid-test) ratio
A measure of liquidity calculated
by dividing the firm’s current
assets minus inventory by its
current liabilities.
The quick (acid-test) ratio is similar to the current ratio except that it excludes
inventory, which is generally the least liquid current asset. The generally low liquidity of inventory results from two primary factors: (1) many types of inventory
cannot be easily sold because they are partially completed items, special-purpose
items, and the like; and (2) inventory is typically sold on credit, which means that
it becomes an account receivable before being converted into cash. The quick
ratio is calculated as follows:6
Current assets Inventory
Quick ratio Current liabilities
The quick ratio for Bartlett Company in 2003 is
$1,223,000 $289,000
$934,000
1.51
$620,000
$620,000
6. Sometimes the quick ratio is defined as (cash marketable securities accounts receivable) current liabilities. If
a firm were to show as current assets items other than cash, marketable securities, accounts receivable, and inventories, its quick ratio might vary, depending on the method of calculation.
CHAPTER 2
Financial Statements and Analysis
55
A quick ratio of 1.0 or greater is occasionally recommended, but as with the
current ratio, what value is acceptable depends largely on the industry. The quick
ratio provides a better measure of overall liquidity only when a firm’s inventory
cannot be easily converted into cash. If inventory is liquid, the current ratio is a
preferred measure of overall liquidity.
Review Question
2–8
LG3
Under what circumstances would the current ratio be the preferred measure of overall firm liquidity? Under what circumstances would the quick
ratio be preferred?
2.4 Activity Ratios
activity ratios
Measure the speed with which
various accounts are converted
into sales or cash—inflows or
outflows.
Activity ratios measure the speed with which various accounts are converted into
sales or cash—inflows or outflows. With regard to current accounts, measures of
liquidity are generally inadequate because differences in the composition of a
firm’s current assets and current liabilities can significantly affect its “true” liquidity. It is therefore important to look beyond measures of overall liquidity and
to assess the activity (liquidity) of specific current accounts. A number of ratios
are available for measuring the activity of the most important current accounts,
which include inventory, accounts receivable, and accounts payable.7 The efficiency with which total assets are used can also be assessed.
Inventory Turnover
inventory turnover
Measures the activity, or liquidity, of a firm’s inventory.
Inventory turnover commonly measures the activity, or liquidity, of a firm’s
inventory. It is calculated as follows:
Cost of goods sold
Inventory turnover Inventory
Applying this relationship to Bartlett Company in 2003 yields
$2,088,000
Inventory turnover 7.2
$289,000
The resulting turnover is meaningful only when it is compared with that of other
firms in the same industry or to the firm’s past inventory turnover. An inventory
7. For convenience, the activity ratios involving these current accounts assume that their end-of-period values are
good approximations of the average account balance during the period—typically 1 year. Technically, when the
month-end balances of inventory, accounts receivable, or accounts payable vary during the year, the average balance, calculated by summing the 12 month-end account balances and dividing the total by 12, should be used
instead of the year-end value. If month-end balances are unavailable, the average can be approximated by dividing
the sum of the beginning-of-year and end-of-year balances by 2. These approaches ensure a ratio that on the average
better reflects the firm’s circumstances. Because the data needed to find averages are generally unavailable to the
external analyst, year-end values are frequently used to calculate activity ratios for current accounts.
56
PART 1
Introduction to Managerial Finance
average age of inventory
Average number of days’ sales
in inventory.
turnover of 20.0 would not be unusual for a grocery store, whereas a common
inventory turnover for an aircraft manufacturer is 4.0.
Inventory turnover can be easily converted into an average age of inventory
by dividing it into 360—the assumed number of days in a year.8 For Bartlett
Company, the average age of inventory in 2003 is 50.0 days (360 7.2). This
value can also be viewed as the average number of days’ sales in inventory.
Average Collection Period
average collection period
The average amount of time
needed to collect accounts
receivable.
The average collection period, or average age of accounts receivable, is useful in
evaluating credit and collection policies.9 It is arrived at by dividing the average
daily sales10 into the accounts receivable balance:
Accounts receivable
Average collection period Average sales per day
Accounts receivable
Annual sales
360
The average collection period for Bartlett Company in 2003 is
$503,000
$503,000
58.9 days
$3,074,000
$8,539
360
On the average, it takes the firm 58.9 days to collect an account receivable.
The average collection period is meaningful only in relation to the firm’s
credit terms. If Bartlett Company extends 30-day credit terms to customers, an
average collection period of 58.9 days may indicate a poorly managed credit or
collection department, or both. It is also possible that the lengthened collection
period resulted from an intentional relaxation of credit-term enforcement in
response to competitive pressures. If the firm had extended 60-day credit terms,
the 58.9-day average collection period would be quite acceptable. Clearly, additional information is needed to evaluate the effectiveness of the firm’s credit and
collection policies.
Average Payment Period
average payment period
The average amount of time
needed to pay accounts payable.
The average payment period, or average age of accounts payable, is calculated in
the same manner as the average collection period:
Accounts payable
Average payment period Average purchases per day
8. Unless otherwise specified, a 360-day year consisting of twelve 30-day months is assumed throughout this textbook. This assumption simplifies the calculations used to illustrate key concepts.
9. The average collection period is sometimes called the days’ sales outstanding (DSO). A discussion of the evaluation and establishment of credit and collection policies is presented in Chapter 14.
10. The formula as presented assumes, for simplicity, that all sales are made on a credit basis. If this is not the case,
average credit sales per day should be substituted for average sales per day.
CHAPTER 2
Financial Statements and Analysis
57
Accounts payable
Annual purchases
360
The difficulty in calculating this ratio stems from the need to find annual purchases,11 a value not available in published financial statements. Ordinarily, purchases are estimated as a given percentage of cost of goods sold. If we assume
that Bartlett Company’s purchases equaled 70 percent of its cost of goods sold in
2003, its average payment period is
$382,000
$382,000
94.1 days
$4,060
0.70 $2,088,000
360
This figure is meaningful only in relation to the average credit terms extended to
the firm. If Bartlett Company’s suppliers have extended, on average, 30-day
credit terms, an analyst would give Bartlett a low credit rating. Prospective
lenders and suppliers of trade credit are most interested in the average payment
period because it provides insight into the firm’s bill-paying patterns.
Total Asset Turnover
total asset turnover
Indicates the efficiency with
which the firm uses its assets to
generate sales.
The total asset turnover indicates the efficiency with which the firm uses its assets
to generate sales. Total asset turnover is calculated as follows:
Sales
Total asset turnover Total assets
The value of Bartlett Company’s total asset turnover in 2003 is
$3,074,000
0.85
$3,597,000
Hint
The higher the cost of
the new assets, the larger the
denominator and thus the
smaller the ratio. Therefore,
because of inflation and the use
of historical costs, firms with
newer assets will tend to have
lower turnovers than those with
older assets.
This means the company turns over its assets 0.85 times a year.
Generally, the higher a firm’s total asset turnover, the more efficiently its
assets have been used. This measure is probably of greatest interest to management, because it indicates whether the firm’s operations have been financially
efficient.
Review Question
2–9
To assess the firm’s average collection period and average payment period
ratios, what additional information is needed, and why?
11. Technically, annual credit purchases—rather than annual purchases—should be used in calculating this ratio.
For simplicity, this refinement is ignored here.
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LG4
2.5 Debt Ratios
financial leverage
The magnification of risk and
return introduced through the use
of fixed-cost financing, such as
debt and preferred stock.
EXAMPLE
degree of indebtedness
Measures the amount of debt
relative to other significant
balance sheet amounts.
ability to service debts
The ability of a firm to make
the payments required on a
scheduled basis over the life
of a debt.
coverage ratios
Ratios that measure the firm’s
ability to pay certain fixed
charges.
The debt position of a firm indicates the amount of other people’s money being
used to generate profits. In general, the financial analyst is most concerned with
long-term debts, because these commit the firm to a stream of payments over the
long run. Because creditors’ claims must be satisfied before the earnings can be distributed to shareholders, present and prospective shareholders pay close attention
to the firm’s ability to repay debts. Lenders are also concerned about the firm’s
indebtedness. Management obviously must be concerned with indebtedness.
In general, the more debt a firm uses in relation to its total assets, the greater
its financial leverage. Financial leverage is the magnification of risk and return
introduced through the use of fixed-cost financing, such as debt and preferred
stock. The more fixed-cost debt a firm uses, the greater will be its expected risk
and return.
Patty Akers is in the process of incorporating her new business. After much
analysis she determined that an initial investment of $50,000—$20,000 in current assets and $30,000 in fixed assets—is necessary. These funds can be
obtained in either of two ways. The first is the no-debt plan, under which she
would invest the full $50,000 without borrowing. The other alternative, the debt
plan, involves investing $25,000 and borrowing the balance of $25,000 at 12%
annual interest.
Regardless of which alternative she chooses, Patty expects sales to average
$30,000, costs and operating expenses to average $18,000, and earnings to be
taxed at a 40% rate. Projected balance sheets and income statements associated
with the two plans are summarized in Table 2.6. The no-debt plan results in
after-tax profits of $7,200, which represent a 14.4% rate of return on Patty’s
$50,000 investment. The debt plan results in $5,400 of after-tax profits, which
represent a 21.6% rate of return on Patty’s investment of $25,000. The debt plan
provides Patty with a higher rate of return, but the risk of this plan is also greater,
because the annual $3,000 of interest must be paid before receipt of earnings.
The example demonstrates that with increased debt comes greater risk as
well as higher potential return. Therefore, the greater the financial leverage, the
greater the potential risk and return. A detailed discussion of the impact of debt
on the firm’s risk, return, and value is included in Chapter 12. Here, we emphasize the use of financial debt ratios to assess externally a firm’s debt position.
There are two general types of debt measures: measures of the degree of
indebtedness and measures of the ability to service debts. The degree of indebtedness measures the amount of debt relative to other significant balance sheet
amounts. A popular measure of the degree of indebtedness is the debt ratio.
The second type of debt measure, the ability to service debts, reflects a firm’s
ability to make the payments required on a scheduled basis over the life of a
debt.12 The firm’s ability to pay certain fixed charges is measured using coverage
ratios. Typically, higher coverage ratios are preferred, but too high a ratio (above
12. The term service refers to the payment of interest and repayment of principal associated with a firm’s debt obligations. When a firm services its debts, it pays—or fulfills—these obligations.
CHAPTER 2
TABLE 2.6
Financial Statements and Analysis
59
Financial Statements Associated with
Patty’s Alternatives
No-debt plan
Debt plan
Current assets
$20,000
$20,000
Fixed assets
30,000
$50,000
$
0
30,000
$50,000
$25,000
50,000
$50,000
25,000
$50,000
$30,000
$30,000
18,000
$12,000
18,000
$12,000
Balance Sheets
Total assets
Debt (12% interest)
(1) Equity
Total liabilities and equity
Income Statements
Sales
Less: Costs and operating
expenses
Operating profits
Less: Interest expense
Net profit before taxes
Less: Taxes (rate = 40%)
0
$12,000
0.12 $25,000 =
3,000
$ 9,000
(2) Net profit after taxes
4,800
$ 7,200
3,600
$ 5,400
Return on equity [(2) (1)]
$7,200
14.4%
$50,000 $5,400
21.6%
$25,000 industry norms) may result in unnecessarily low risk and return. In general, the
lower the firm’s coverage ratios, the less certain it is to be able to pay fixed obligations. If a firm is unable to pay these obligations, its creditors may seek immediate repayment, which in most instances would force a firm into bankruptcy.
Two popular coverage ratios are the times interest earned ratio and the fixedpayment coverage ratio.13
Debt Ratio
debt ratio
Measures the proportion of total
assets financed by the firm’s
creditors.
The debt ratio measures the proportion of total assets financed by the firm’s creditors. The higher this ratio, the greater the amount of other people’s money being
used to generate profits. The ratio is calculated as follows:
Total liabilities
Debt ratio Total assets
13. Coverage ratios use data that are derived on an accrual basis (discussed in Chapter 1) to measure what in a strict
sense should be measured on a cash basis. This occurs because debts are serviced by using cash flows, not the
accounting values shown on the firm’s financial statements. But because it is difficult to determine cash flows available for debt service from the firm’s financial statements, the calculation of coverage ratios as presented here is quite
common thanks to the ready availability of financial statement data.
60
PART 1
Introduction to Managerial Finance
The debt ratio for Bartlett Company in 2003 is
$1,643,000
0.457 45.7%
$3,597,000
This value indicates that the company has financed close to half of its assets with
debt. The higher this ratio, the greater the firm’s degree of indebtedness and the
more financial leverage it has.
Times Interest Earned Ratio
times interest earned ratio
Measures the firm’s ability to
make contractual interest
payments; sometimes called the
interest coverage ratio.
The times interest earned ratio, sometimes called the interest coverage ratio, measures the firm’s ability to make contractual interest payments. The higher its
value, the better able the firm is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:
Earnings before interest and taxes
Times interest earned ratio Interest
The figure for earnings before interest and taxes is the same as that for operating
profits shown in the income statement. Applying this ratio to Bartlett Company
yields the following 2003 value:
$418,000
Times interest earned ratio 4.5
$93,000
The times interest earned ratio for Bartlett Company seems acceptable. A value
of at least 3.0—and preferably closer to 5.0—is often suggested. The firm’s
earnings before interest and taxes could shrink by as much as 78 percent
[(4.5 1.0) 4.5], and the firm would still be able to pay the $93,000 in interest
it owes. Thus it has a good margin of safety.
Fixed-Payment Coverage Ratio
fixed-payment coverage ratio
Measures the firm’s ability to
meet all fixed-payment
obligations.
The fixed-payment coverage ratio measures the firm’s ability to meet all fixedpayment obligations, such as loan interest and principal, lease payments, and preferred stock dividends.14 As is true of the times interest earned ratio, the higher
this value, the better. The formula for the fixed-payment coverage ratio is
FixedEarnings before interest and taxes Lease payments
payment Interest Lease payments
coverage
{(Principal
payments
Preferred stock dividends) [1/(1 T)]}
ratio
where T is the corporate tax rate applicable to the firm’s income. The term
1/(1 T) is included to adjust the after-tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-
14. Although preferred stock dividends, which are stated at the time of issue, can be “passed” (not paid) at the
option of the firm’s directors, it is generally believed that the payment of such dividends is necessary. This text therefore treats the preferred stock dividend as a contractual obligation, to be paid as a fixed amount, as scheduled.
CHAPTER 2
Financial Statements and Analysis
61
tax values of all other terms. Applying the formula to Bartlett Company’s 2003
data yields
$418,000 $35,000
Fixed-payment
coverage ratio $93,000 $35,000 {($71,000 $10,000) [1/(1 0.29)]}
$453,000
1.9
$242,000
Because the earnings available are nearly twice as large as its fixed-payment
obligations, the firm appears safely able to meet the latter.
Like the times interest earned ratio, the fixed-payment coverage ratio measures risk. The lower the ratio, the greater the risk to both lenders and owners;
the greater the ratio, the lower the risk. This ratio allows interested parties to
assess the firm’s ability to meet additional fixed-payment obligations without
being driven into bankruptcy.
Review Questions
2–10 What is financial leverage?
2–11 What ratio measures the firm’s degree of indebtedness? What ratios assess
the firm’s ability to service debts?
LG5
2.6 Profitability Ratios
There are many measures of profitability. As a group, these measures enable the
analyst to evaluate the firm’s profits with respect to a given level of sales, a certain level of assets, or the owners’ investment. Without profits, a firm could not
attract outside capital. Owners, creditors, and management pay close attention to
boosting profits because of the great importance placed on earnings in the
marketplace.
Common-Size Income Statements
common-size income statement
An income statement in which
each item is expressed as a
percentage of sales.
A popular tool for evaluating profitability in relation to sales is the common-size
income statement.15 Each item on this statement is expressed as a percentage of
sales. Common-size income statements are especially useful in comparing performance across years. Three frequently cited ratios of profitability that can be read
directly from the common-size income statement are (1) the gross profit margin,
(2) the operating profit margin, and (3) the net profit margin.
Common-size income statements for 2003 and 2002 for Bartlett Company
are presented and evaluated in Table 2.7. These statements reveal that the firm’s
15. This statement is sometimes called a percent income statement. The same treatment is often applied to the firm’s
balance sheet to make it easier to evaluate changes in the asset and financial structures of the firm. In addition to
measuring profitability, these statements in effect can be used as an alternative or supplement to liquidity, activity,
and debt-ratio analysis.
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TABLE 2.7
Bartlett Company Common-Size Income
Statements
For the years ended
December 31
Evaluationa
2003
2002
2002–2003
Sales revenue
100.0%
100.0%
same
Less: Cost of goods sold
6
7
.9
3
2
.1
%
6
6
.7
3
3
.3
%
worse
worse
Selling expense
3.3%
4.2%
better
General and administrative expenses
6.8
6.7
better
Lease expense
1.1
1.3
better
7
.3
18.5%
13.6%
9
.3
21.5%
11.8%
better
better
3
.0
10.6%
3
.5
8.3%
better
3
.1
7.5%
2
.5
5.8%
better
0.3
7
.2
%
0.4
5
.4
%
(1) Gross profit margin
Less: Operating expenses
Depreciation expense
Total operating expense
(2) Operating profit margin
Less: Interest expense
Net profits before taxes
Less: Taxes
Net profits after taxes
Less: Preferred stock dividends
(3) Net profit margin
better
better
worseb
better
better
aSubjective
assessments based on data provided.
as a percent of sales increased noticeably between 2002 and 2003 because of differing costs and
expenses, whereas the average tax rates (taxes net profits before taxes) for 2002 and 2003 remained
about the same—30% and 29%, respectively.
bTaxes
cost of goods sold increased from 66.7 percent of sales in 2002 to 67.9 percent in
2003, resulting in a worsening gross profit margin. However, thanks to a
decrease in total operating expenses, the firm’s net profit margin rose from 5.4
percent of sales in 2002 to 7.2 percent in 2003. The decrease in expenses more
than compensated for the increase in the cost of goods sold. A decrease in the
firm’s 2003 interest expense (3.0 percent of sales versus 3.5 percent in 2002)
added to the increase in 2003 profits.
Gross Profit Margin
gross profit margin
Measures the percentage of each
sales dollar remaining after the
firm has paid for its goods.
The gross profit margin measures the percentage of each sales dollar remaining
after the firm has paid for its goods. The higher the gross profit margin, the better
(that is, the lower the relative cost of merchandise sold). The gross profit margin
is calculated as follows:
Gross profits
Sales Cost of goods sold
Gross profit margin Sales
Sales
CHAPTER 2
FOCUS ON e-FINANCE
margin, when sales numbers were
down, the ShopKo’s gross profit
margin also suffered.
Software from Spotlight
Solutions, a Cincinnati company,
applied information technology to
ShopKo’s decisions about markdowns. Company research indicated that multiple markdowns are
not so profitable as properly timed
single markdowns. It developed a
program (Markdown Optimizer) to
automate optimal price change actions so that retailers can achieve
higher sales and margins from existing merchandise inventories.
The program analyzes several
years of sales figures on similar
products and develops a demand
pattern, taking into account the
sensitivity of customer demand to
price changes (price elasticity).
The software is dynamic—that is,
it “learns” retail customers’ preferences and incorporates that information into its models.
63
In Practice
ShopKo’s Software Solution
Specialized financial analysis tools
can help companies achieve significant improvements in ratio
measures of performance. With
assistance from sophisticated new
software programs, for example,
companies can convert masses of
historical sales data into useful
information that guides pricing
strategy and improves operating
efficiency.
Like many of its rivals,
ShopKo Stores, a Fortune 500 discount chain based in Green Bay,
Wisconsin, had no underlying
strategy to sell slow-moving
items. It used “guesstimates” to
reduce prices a bit at a time, until
eventually the merchandise sold.
However, total sales suffered from
the company’s having no way to
determine the maximum price at
which goods would sell. Because
the dollar volume of sales enters
into both the numerator and the
denominator in the gross profit
Hint This is a very
significant ratio for small
retailers, especially during times
of inflationary prices. If the
owner of the firm does not raise
prices when the cost of sales is
rising, the gross profit margin
will erode.
Financial Statements and Analysis
During a six-month pilot project, ShopKo provided three years
of sales data on 300 apparel, home,
and other products. Markdown
Optimizer ran through a series of
mathematical models to arrive at
optimal timing for and amount of
price cuts. ShopKo tracked and
compared sales for these clearance items using the recommended markdowns. Sales on
those products were 14 percent
higher than the prior year. The
company’s gross profit margin
rose 24 percent, despite flat samestore sales in one quarter. ShopKo
now uses Markdown Optimizer for
all products.
Sources: Amy Merrick, “Retailers Try to Get
Leg Up on Markdowns with New Software,”
Wall Street Journal (August 7, 2001), pp. A1,
A6; “ShopKo Uses Spotlight Solutions
Price Optimization Software,” downloaded
from Spotlight Solutions Web site, www.
spotlightsolutions.com/cshopko.html,
November 6, 2001.
Bartlett Company’s gross profit margin for 2003 is
$986,000
$3,074,000 $2,088,000
32.1%
$3,074,000
$3,074,000
This value is labeled (1) on the common-size income statement in Table 2.7.
Operating Profit Margin
operating profit margin
Measures the percentage of each
sales dollar remaining after all
costs and expenses other than
interest, taxes, and preferred
stock dividends are deducted;
the “pure profits” earned on each
sales dollar.
The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. It represents the “pure profits” earned on each sales dollar.
Operating profits are “pure” because they measure only the profits earned on
operations and ignore interest, taxes, and preferred stock dividends. A high operating profit margin is preferred. The operating profit margin is calculated as
follows:
Operating profits
Operating profit margin Sales
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Introduction to Managerial Finance
Bartlett Company’s operating profit margin for 2003 is
$418,000
13.6%
$3,074,000
This value is labeled (2) on the common-size income statement in Table 2.7.
Net Profit Margin
net profit margin
Measures the percentage of each
sales dollar remaining after all
costs and expenses, including
interest, taxes, and preferred
stock dividends, have been
deducted.
The net profit margin measures the percentage of each sales dollar remaining
after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher the firm’s net profit margin, the better.
The net profit margin is calculated as follows:
Earnings available for common stockholders
Net profit margin Sales
Bartlett Company’s net profit margin for 2003 is
$221,000
7.2%
$3,074,000
This value is labeled (3) on the common-size income statement in Table 2.7.
The net profit margin is a commonly cited measure of the firm’s success with
respect to earnings on sales. “Good” net profit margins differ considerably across
industries. A net profit margin of 1 percent or less would not be unusual for a
grocery store, whereas a net profit margin of 10 percent would be low for a retail
jewelry store.
Earnings per Share (EPS)
Hint EPS represents the
dollar amount earned on behalf
of each share—not the amount
of earnings actually distributed
to shareholders.
The firm’s earnings per share (EPS) is generally of interest to present or prospective stockholders and management. As we noted earlier, EPS represents the number of dollars earned during the period on behalf of each outstanding share of
common stock. Earnings per share is calculated as follows:
Earnings available for common stockholders
Earnings per share Number of shares of common stock outstanding
Bartlett Company’s earnings per share in 2003 is
$221,000
$2.90
76,262
This figure represents the dollar amount earned on behalf of each share. The dollar amount of cash actually distributed to each shareholder is the dividend per
share (DPS), which, as noted in Bartlett Company’s income statement (Table
2.1), rose to $1.29 in 2003 from $0.75 in 2002. EPS is closely watched by the
investing public and is considered an important indicator of corporate success.
CHAPTER 2
Financial Statements and Analysis
65
Return on Total Assets (ROA)
return on total assets (ROA)
Measures the overall effectiveness of management in generating profits with its available
assets; also called the return on
investment (ROI).
The return on total assets (ROA), often called the return on investment (ROI),
measures the overall effectiveness of management in generating profits with its
available assets. The higher the firm’s return on total assets, the better. The return
on total assets is calculated as follows:
Earnings available for common stockholders
Return on total assets Total assets
Bartlett Company’s return on total assets in 2003 is
$221,000
6.1%
$3,597,000
This value indicates that the firm earned 6.1 cents on each dollar of asset
investment.
Return on Common Equity (ROE)
return on common equity (ROE)
Measures the return earned on
the common stockholders’
investment in the firm.
The return on common equity (ROE) measures the return earned on the common
stockholders’ investment in the firm. Generally, the higher this return, the better
off are the owners. Return on common equity is calculated as follows:
Earnings available for common stockholders
Return on common equity Common stock equity
This ratio for Bartlett Company in 2003 is
$221,000
12.6%
$1,754,000
Note that the value for common stock equity ($1,754,000) was found by subtracting the $200,000 of preferred stock equity from the total stockholders’
equity of $1,954,000 (see Bartlett Company’s 2003 balance sheet in Table 2.2).
The calculated ROE of 12.6 percent indicates that during 2003 Bartlett earned
12.6 cents on each dollar of common stock equity.
Review Questions
2–12 What three ratios of profitability are found on a common-size income
statement?
2–13 What would explain a firm’s having a high gross profit margin and a low
net profit margin?
2–14 Which measure of profitability is probably of greatest interest to the
investing public? Why?
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LG5
2.7 Market Ratios
market ratios
Relate a firm’s market value, as
measured by its current share
price, to certain accounting
values.
Market ratios relate the firm’s market value, as measured by its current share
price, to certain accounting values. These ratios give insight into how well
investors in the marketplace feel the firm is doing in terms of risk and return.
They tend to reflect, on a relative basis, the common stockholders’ assessment of
all aspects of the firm’s past and expected future performance. Here we consider
two popular market ratios, one that focuses on earnings and another that considers book value.
Price/Earnings (P/E) Ratio
price/earnings (P/E) ratio
Measures the amount that
investors are willing to pay for
each dollar of a firm’s earnings;
the higher the P/E ratio, the
greater is investor confidence.
The price/earnings (P/E) ratio is commonly used to assess the owners’ appraisal
of share value.16 The P/E ratio measures the amount that investors are willing to
pay for each dollar of a firm’s earnings. The level of the price/earnings ratio indicates the degree of confidence that investors have in the firm’s future performance. The higher the P/E ratio, the greater is investor confidence. The P/E ratio
is calculated as follows:
Market price per share of common stock
Price/earnings (P/E) ratio Earnings per share
If Bartlett Company’s common stock at the end of 2003 was selling at $32.25,
using the EPS of $2.90, the P/E ratio at year-end 2003 is
$32.25
11.1
$2.90
This figure indicates that investors were paying $11.10 for each $1.00 of earnings. The P/E ratio is most informative when applied in cross-sectional analysis
using an industry average P/E ratio or the P/E ratio of a benchmark firm.
Market/Book (M/B) Ratio
market/book (M/B) ratio
Provides an assessment of how
investors view the firm’s performance. Firms expected to earn
high returns relative to their risk
typically sell at higher M/B
multiples.
The market/book (M/B) ratio provides an assessment of how investors view the
firm’s performance. It relates the market value of the firm’s shares to their
book—strict accounting—value. To calculate the firm’s M/B ratio, we first need
to find the book value per share of common stock:
Common stock equity
Book value per
share of common stock Number of shares of common stock outstanding
Substituting the appropriate values for Bartlett Company from its 2003 balance
sheet, we get
$1,754,000
Book value per share of common stock $23.00
76,262
16. Use of the price/earnings ratio to estimate the value of the firm is part of the discussion of “Other approaches to
common stock valuation” in Chapter 7.
CHAPTER 2
Financial Statements and Analysis
67
The formula for the market/book ratio is
Market price per share of common stock
Market/book (M/B) ratio Book value per share of common stock
Substituting Bartlett Company’s end of 2003 common stock price of $32.25 and
its $23.00 book value per share of common stock (calculated above) into the M/B
ratio formula, we get
$32.25
Market/book (M/B) ratio 1.40
$23.00
This M/B ratio means that investors are currently paying $1.40 for each $1.00 of
book value of Bartlett Company’s stock.
The stocks of firms that are expected to perform well—improve profits,
increase their market share, or launch successful products—typically sell at
higher M/B ratios than the stocks of firms with less attractive outlooks. Simply
stated, firms expected to earn high returns relative to their risk typically sell at
higher M/B multiples. Clearly, Bartlett’s future prospects are being viewed favorably by investors, who are willing to pay more than its book value for the firm’s
shares. Like P/E ratios, M/B ratios are typically assessed cross-sectionally, to get a
feel for the firm’s risk and return compared to peer firms.
Review Question
2–15 How do the price/earnings (P/E) ratio and the market/book (M/B) ratio
provide a feel for the firm’s risk and return?
LG6
2.8 A Complete Ratio Analysis
Analysts frequently wish to take an overall look at the firm’s financial performance and status. Here we consider two popular approaches to a complete ratio
analysis: (1) summarizing all ratios and (2) the DuPont system of analysis. The
summary analysis approach tends to view all aspects of the firm’s financial activities to isolate key areas of responsibility. The DuPont system acts as a search
technique aimed at finding the key areas responsible for the firm’s financial
condition.
Summarizing All Ratios
We can use Bartlett Company’s ratios to perform a complete ratio analysis using
both cross-sectional and time-series analysis approaches. The 2003 ratio values
calculated earlier and the ratio values calculated for 2001 and 2002 for Bartlett
Company, along with the industry average ratios for 2003, are summarized in
Table 2.8, which also shows the formula used to calculate each ratio. Using these
data, we can discuss the five key aspects of Bartlett’s performance—liquidity,
activity, debt, profitability, and market.
68
5.1
5.7
1.32
good
2.08
2002b
Earnings before interest and taxes
Interest
1.5
good
Times interest earned ratio
1.9
OK
3.3
44.3%
0.94
81.2 days
4.5
45.7%
0.79
94.1 days
51.2 days
7.2
1.46
1.97
2003b
4.3
40.0%
0.85
66.5 days
58.9 days
6.6
1.51
2.05
Industry
average
2003c
good
OK
0.75
poor
44.3 days
good
1.43
OK
Crosssectional
2003
Earnings before interest and taxes Lease payments
Fixed-payment coverage ratio Int. Lease pay. {(Prin. Pref. div.) [1/(1 T)]}
good
5.6
36.8%
OK
75.8 days
Sales
Total asset turnover Total assets
Total liabilities
Total assets
Accounts payable
Average purchases per day
Accounts receivable
Average collection period 43.9 days
Average sales per day
Debt ratio
Debt
Average payment period
poor
2.04
2001a
Current assets Inventory
Quick (acid-test) ratio Current liabilities
Cost of goods sold
Inventory
Current assets
Current liabilities
Formula
Year
Summary of Bartlett Company Ratios (2001–2003, Including 2003 Industry Averages)
Inventory turnover
Activity
Current ratio
Liquidity
Ratio
TABLE 2.8
2.4
OK
OK
OK
poor
poor
good
OK
OK
Timeseries
2001–2003
Evaluationd
1.4
OK
OK
OK
poor
poor
good
good
OK
Overall
69
$2.26
good
Earnings available for common stockholders
Total assets
OK
$2.90
OK
Return on total assets
(ROA)
Return on common equity
(ROE)
good
good
bCalculated
from data not included in the chapter.
by using the financial statements presented in Tables 2.1 and 2.2.
1.30
OK
1.40
OK
aCalculated
Market price per share of common stock
Earnings per share
Price/earnings (P/E) ratio
Market
Earnings available for common stockholders
Sales
Net profit margin
Operating profit margin
5.4%
14.6%
33.3%
2002b
7.2%
11.8%
32.1%
2003b
6.2%
13.6%
30.0%
Industry
average
2003c
good
11.0%
OK
Crosssectional
2003
OK
good
OK
Timeseries
2001–2003
4.2%
6.1%
10.0e
11.1
12.5
13.7%
4.6%
OK
8.5%
good
Market price per share of common stock
Market/book (M/B) ratio Book value per share of common stock
OK
10.5
Earnings available for common stockholders
Common stock equity
7.8%
1.25
OK
12.6%
OK
Earnings available for common stockholders
Earnings per share (EPS) $3.26
Number of shares of common stock outstanding
good
8.2%
good
31.4%
2001a
Operating profits
Sales
Gross profits
Sales
Formula
Gross profit margin
Profitability
Ratio
Year
Evaluationd
0.85e
OK
8.5%
good
$1.81
good
OK
OK
Overall
70
PART 1
Introduction to Managerial Finance
Liquidity
The overall liquidity of the firm seems to exhibit a reasonably stable trend, having been maintained at a level that is relatively consistent with the industry average in 2003. The firm’s liquidity seems to be good.
Activity
Bartlett Company’s inventory appears to be in good shape. Its inventory management seems to have improved, and in 2003 it performed at a level above that of
the industry. The firm may be experiencing some problems with accounts receivable. The average collection period seems to have crept up above that of the
industry. Bartlett also appears to be slow in paying its bills; it pays nearly 30 days
slower than the industry average. This could adversely affect the firm’s credit
standing. Although overall liquidity appears to be good, the management of
receivables and payables should be examined. Bartlett’s total asset turnover
reflects a decline in the efficiency of total asset utilization between 2001 and
2002. Although in 2003 it rose to a level considerably above the industry average, it appears that the pre-2002 level of efficiency has not yet been achieved.
Debt
Bartlett Company’s indebtedness increased over the 2001–2003 period and is
currently above the industry average. Although this increase in the debt ratio
could be cause for alarm, the firm’s ability to meet interest and fixed-payment
obligations improved, from 2002 to 2003, to a level that outperforms the industry. The firm’s increased indebtedness in 2002 apparently caused a deterioration
in its ability to pay debt adequately. However, Bartlett has evidently improved its
income in 2003 so that it is able to meet its interest and fixed-payment obligations at a level consistent with the average in the industry. In summary, it appears
that although 2002 was an off year, the company’s ability to pay debts in 2003
compensates for its increased degree of indebtedness.
Profitability
Bartlett’s profitability relative to sales in 2003 was better than the average company in the industry, although it did not match the firm’s 2001 performance.
Although the gross profit margin was better in 2002 and 2003 than in 2001,
higher levels of operating and interest expenses in 2002 and 2003 appear to have
caused the 2003 net profit margin to fall below that of 2001. However, Bartlett
Company’s 2003 net profit margin is quite favorable when compared to the
industry average.
The firm’s earnings per share, return on total assets, and return on common
equity behaved much as its net profit margin did over the 2001–2003 period.
Bartlett appears to have experienced either a sizable drop in sales between 2001
and 2002 or a rapid expansion in assets during that period. The exceptionally
high 2003 level of return on common equity suggests that the firm is performing
quite well. The firm’s above-average returns—net profit margin, EPS, ROA, and
ROE—may be attributable to the fact that it is more risky than average. A look at
market ratios is helpful in assessing risk.
CHAPTER 2
Financial Statements and Analysis
71
Market
Investors have greater confidence in the firm in 2003 than in the prior two years,
as reflected in the price/earnings (P/E) ratio of 11.1. However, this ratio is below
the industry average. The P/E ratio suggests that the firm’s risk has declined but
remains above that of the average firm in its industry. The firm’s market/book
(M/B) ratio has increased over the 2001–2003 period, and in 2003 it exceeds the
industry average. This implies that investors are optimistic about the firm’s future
performance. The P/E and M/B ratios reflect the firm’s increased profitability
over the 2001–2003 period: Investors expect to earn high future returns as compensation for the firm’s above-average risk.
In summary, the firm appears to be growing and has recently undergone an
expansion in assets, financed primarily through the use of debt. The 2002–2003
period seems to reflect a phase of adjustment and recovery from the rapid growth
in assets. Bartlett’s sales, profits, and other performance factors seem to be growing with the increase in the size of the operation. In addition, the market response
to these accomplishments appears to have been positive. In short, the firm seems
to have done well in 2003.
DuPont System of Analysis
DuPont system of analysis
System used to dissect the firm’s
financial statements and to
assess its financial condition.
DuPont formula
Multiplies the firm’s net profit
margin by its total asset turnover
to calculate the firm’s return on
total assets (ROA).
The DuPont system of analysis is used to dissect the firm’s financial statements
and to assess its financial condition. It merges the income statement and balance
sheet into two summary measures of profitability: return on total assets (ROA)
and return on common equity (ROE). Figure 2.2 depicts the basic DuPont system
with Bartlett Company’s 2003 monetary and ratio values. The upper portion of
the chart summarizes the income statement activities; the lower portion summarizes the balance sheet activities.
The DuPont system first brings together the net profit margin, which measures
the firm’s profitability on sales, with its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales. In the DuPont formula, the
product of these two ratios results in the return on total assets (ROA):
ROA Net profit margin Total asset turnover
Substituting the appropriate formulas into the equation and simplifying results in
the formula given earlier,
Earnings available for
Earnings available for
common stockholders
Sales
common stockholders
ROA Sales
Total assets
Total assets
When the 2003 values of the net profit margin and total asset turnover for
Bartlett Company, calculated earlier, are substituted into the DuPont formula, the
result is
ROA 7.2% 0.85 6.1%
This value is the same as that calculated directly in an earlier section (page 65).
The DuPont formula enables the firm to break down its return into profit-onsales and efficiency-of-asset-use components. Typically, a firm with a low net
profit margin has a high total asset turnover, which results in a reasonably good
return on total assets. Often, the opposite situation exists.
PART 1
Introduction to Managerial Finance
FIGURE 2.2
DuPont System of Analysis
The DuPont system of analysis with application to Bartlett Company (2003)
Sales
$3,074,000
minus
Income
Statement
Cost of
Goods Sold
$2,088,000
minus
Operating
Expenses
$568,000
minus
Earnings
Available
for Common
Stockholders
$221,000
divided by
Net Profit
Margin
7.2%
Sales
$3,074,000
Interest
Expense
$93,000
minus
Taxes
$94,000
multiplied
by
minus
Return on
Total Assets
(ROA)
6.1%
Preferred Stock
Dividends
$10,000
Sales
$3,074,000
Balance
Sheet
72
Current
Assets
$1,223,000
divided by
plus
Total Assets
$3,597,000
Total Asset
Turnover
0.85
multiplied
by
Net Fixed
Assets
$2,374,000
Current
Liabilities
$620,000
plus
Long-Term
Debt
$1,023,000
Total
Liabilities
$1,643,000
plus
Stockholders’
Equity
$1,954,000
Total Liabilities
and Stockholders’
Equity = Total
Assets
$3,597,000
divided by
Common Stock
Equity
$1,754,000
Financial
Leverage
Multiplier (FLM)
2.06
Return on
Common
Equity (ROE)
12.6%
CHAPTER 2
Financial Statements and Analysis
73
modified DuPont formula
Relates the firm’s return on total
assets (ROA) to its return on
common equity (ROE) using the
financial leverage multiplier
(FLM).
The second step in the DuPont system employs the modified DuPont formula.
This formula relates the firm’s return on total assets (ROA) to its return on common equity (ROE). The latter is calculated by multiplying the return on total
assets (ROA) by the financial leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
financial leverage multiplier
(FLM)
The ratio of the firm’s total assets
to its common stock equity.
ROE ROA FLM
Substituting the appropriate formulas into the equation and simplifying results in
the formula given earlier,
Earnings available for
Earnings available for
common stockholders
common stockholders
Total assets
ROE Total assets
Common stock
Common stock
equity
equity
Use of the financial leverage multiplier (FLM) to convert the ROA into the
ROE reflects the impact of financial leverage on owners’ return. Substituting the
values for Bartlett Company’s ROA of 6.1 percent, calculated earlier, and
Bartlett’s FLM of 2.06 ($3,597,000 total assets $1,754,000 common stock
equity) into the modified DuPont formula yields
ROE 6.1% 2.06 12.6%
The 12.6 percent ROE calculated by using the modified DuPont formula is the
same as that calculated directly (page 65).
The advantage of the DuPont system is that it allows the firm to break its return
on equity into a profit-on-sales component (net profit margin), an efficiency-ofasset-use component (total asset turnover), and a use-of-financial-leverage component (financial leverage multiplier). The total return to owners therefore can be
analyzed in these important dimensions.
The use of the DuPont system of analysis as a diagnostic tool is best explained using Figure 2.2. Beginning with the rightmost value—the ROE—the
financial analyst moves to the left, dissecting and analyzing the inputs to the formula in order to isolate the probable cause of the resulting above-average (or
below-average) value. For the sake of discussion, let’s assume that Bartlett’s ROE
of 12.6 percent is actually below the industry average. Moving to the left, we
would examine the inputs to the ROE—the ROA and the FLM—relative to the
industry averages. Let’s assume that the FLM is in line with the industry average,
but the ROA is below the industry average. Moving farther to the left, we examine the two inputs to the ROA—the net profit margin and total asset turnover.
Assume that the net profit margin is in line with the industry average, but the
total asset turnover is below the industry average. Moving still farther to the left,
we find that whereas the firm’s sales are consistent with the industry value,
Bartlett’s total assets have grown significantly during the past year. Looking farther to the left, we would review the firm’s activity ratios for current assets. Let’s
say that whereas the firm’s inventory turnover is in line with the industry average,
its average collection period is well above the industry average.
Clearly, we can trace the possible problem back to its cause: Bartlett’s low
ROE is primarily the consequence of slow collections of accounts receivable,
which resulted in high levels of receivables and therefore high levels of total
assets. The high total assets slowed Bartlett’s total asset turnover, driving down
its ROA, which then drove down its ROE. By using the DuPont system of analysis
74
PART 1
Introduction to Managerial Finance
to dissect Bartlett’s overall returns as measured by its ROE, we found that slow
collections of receivables caused the below-industry-average ROE. Clearly, the
firm needs to manage its credit operations better.
Review Questions
2–16 Financial ratio analysis is often divided into five areas: liquidity, activity,
debt, profitability, and market ratios. Differentiate each of these areas of
analysis from the others. Which is of the greatest concern to creditors?
2–17 Describe how you would use a large number of ratios to perform a complete ratio analysis of the firm.
2–18 What three areas of analysis are combined in the modified DuPont formula? Explain how the DuPont system of analysis is used to dissect the
firm’s results and isolate their causes.
S U M M A RY
FOCUS ON VALUE
Financial managers review and analyze the firm’s financial statements periodically, both to
uncover developing problems and to assess the firm’s progress toward achieving its goals.
These actions are aimed at preserving and creating value for the firm’s owners. Financial
ratios enable financial managers to monitor the pulse of the firm and its progress toward its
strategic goals. Although financial statements and financial ratios rely on accrual concepts,
they can provide useful insights into important aspects of risk and return (cash flow) that
affect share price, which management is attempting to maximize.
REVIEW OF LEARNING GOALS
Review the contents of the stockholders’ report and the procedures for consolidating international financial statements. The annual stockholders’ report, which publicly owned corporations
are required to provide to stockholders, documents
the firm’s financial activities during the past year.
It includes the letter to stockholders and various
subjective and factual information, as well as four
key financial statements: the income statement, the
balance sheet, the statement of retained earnings,
and the statement of cash flows. Notes describing
the technical aspects of the financial statements follow them. Financial statements of companies that
have operations whose cash flows are denominated
in one or more foreign currencies must be transLG1
lated into dollars in accordance with FASB
Standard No. 52.
Understand who uses financial ratios, and how.
Ratio analysis enables present and prospective
stockholders and lenders and the firm’s management to evaluate the firm’s financial performance. It
can be performed on a cross-sectional or a timeseries basis. Benchmarking is a popular type of
cross-sectional analysis. Key cautions for applying
financial ratios are: (1) Ratios with large deviations
from the norm only indicate symptoms of a problem. (2) A single ratio does not generally provide
sufficient information. (3) The ratios being compared should be calculated using financial stateLG2
CHAPTER 2
ments dated at the same point in time during the
year. (4) Audited financial statements should be
used. (5) Data should be checked for consistency of
accounting treatment. (6) Inflation and different asset ages can distort ratio comparisons.
Use ratios to analyze a firm’s liquidity and activity. Liquidity, or ability of the firm to pay
its bills as they come due, can be measured by the
current ratio and the quick (acid-test) ratio. Activity ratios measure the speed with which accounts
are converted into sales or cash—inflows or outflows. The activity of inventory can be measured
by its turnover, that of accounts receivable by the
average collection period, and that of accounts
payable by the average payment period. Total asset
turnover measures the efficiency with which the
firm uses its assets to generate sales. Formulas for
these liquidity and activity ratios are summarized
in Table 2.8.
LG3
Discuss the relationship between debt and financial leverage and the ratios used to analyze
a firm’s debt. The more debt a firm uses, the greater
its financial leverage, which magnifies both risk and
return. Financial debt ratios measure both the degree of indebtedness and the ability to service debts.
A common measure of indebtedness is the debt ratio. The ability to pay fixed charges can be measured by times interest earned and fixed-payment
LG4
SELF-TEST PROBLEMS
LG3
LG4
LG5
ST 2–1
Financial Statements and Analysis
75
coverage ratios. Formulas for these debt ratios are
summarized in Table 2.8.
Use ratios to analyze a firm’s profitability and
its market value. The common-size income
statement, which shows all items as a percentage of
sales, can be used to determine gross profit margin,
operating profit margin, and net profit margin.
Other measures of profitability include earnings per
share, return on total assets, and return on common
equity. Market ratios include the price/earnings ratio and the market/book ratio. Formulas for these
profitability and market ratios are summarized in
Table 2.8.
LG5
Use a summary of financial ratios and the
DuPont system of analysis to perform a complete ratio analysis. A summary of all ratios—liquidity, activity, debt, profitability, and market—as
shown in Table 2.8 can be used to perform a complete ratio analysis using cross-sectional and timeseries analysis approaches. The DuPont system of
analysis, summarized in Figure 2.2, is a diagnostic
tool used to find the key areas responsible for the
firm’s financial performance. It enables the firm to
break the return on common equity into three components: profit on sales, efficiency of asset use, and
use of leverage. The DuPont system of analysis
makes it possible to assess all aspects of the firm’s activities in order to isolate key areas of responsibility.
LG6
(Solutions in Appendix B)
Ratio formulas and interpretations Without referring to the text, indicate for
each of the following ratios the formula for calculating it and the kinds of problems, if any, the firm is likely to have if that ratio is too high relative to the
industry average. What if the ratio is too low relative to the industry? Create a
table similar to the one that follows and fill in the empty blocks.
Ratio
Current ratio Inventory turnover Times interest earned Gross profit margin Return on total assets Too high
Too low
76
PART 1
LG3
LG4
LG5
Introduction to Managerial Finance
ST 2–2
Balance sheet completion using ratios Complete the 2003 balance sheet for
O’Keefe Industries using the information that follows it.
O’Keefe Industries
Balance Sheet
December 31, 2003
Assets
Liabilities and Stockholders’ Equity
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
$30,000
25,000
$
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Stockholders’ equity
Total liabilities and
stockholders’ equity
$120,000
20,000
$600,000
$
The following financial data for 2003 are also available:
(1) Sales totaled $1,800,000.
(6) The current ratio was 1.60.
(2) The gross profit margin was 25%.
(7) The total asset turnover ratio
(3) Inventory turnover was 6.0.
was 1.20.
(4) There are 360 days in the year.
(8) The debt ratio was 60%.
(5) The average collection period
was 40 days.
PROBLEMS
LG1
2–1
Reviewing basic financial statements The income statement for the year ended
December 31, 2003, the balance sheets for December 31, 2003 and 2002, and
the statement of retained earnings for the year ended December 31, 2003, for
Technica, Inc., are given here. Briefly discuss the form and informational content
of each of these statements.
Technica, Inc.
Income Statement
for the Year Ended December 31, 2003
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses
General and administrative expense
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes
Earnings available for common stockholders
Earnings per share (EPS)
$600,000
460,000
$140,000
$30,000
30,000
60,000
$ 80,000
10,000
$ 70,000
27,100
$ 42,900
$2.15
CHAPTER 2
Financial Statements and Analysis
77
Technica, Inc.
Balance Sheets
December 31
Assets
2003
2002
Cash
$ 15,000
$ 16,000
7,200
8,000
Marketable securities
Accounts receivable
Inventories
Total current assets
Land and buildings
34,100
42,200
82,000
$138,300
$150,000
50,000
$116,200
$150,000
200,000
190,000
Machinery and equipment
Furniture and fixtures
Other
Total gross fixed assets
Less: Accumulated depreciation
Net fixed assets
Total assets
54,000
50,000
11,000
$415,000
10,000
$400,000
145,000
$270,000
$408,300
115,000
$285,000
$401,200
$ 57,000
$ 49,000
13,000
16,000
5,000
$ 75,000
$150,000
6,000
$ 71,000
$160,000
$110,200
$120,000
73,100
$183,300
$408,300
50,200
$170,200
$401,200
Liabilities and Stockholders’ Equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Stockholders’ equity
Common stock equity (shares
outstanding: 19,500 in 2003 and
20,000 in 2002)
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
Technica, Inc.
Statement of Retained Earnings
for the Year Ended December 31, 2003
Retained earnings balance (January 1, 2003)
Plus: Net profits after taxes (for 2003)
Less: Cash dividends (paid during 2003)
Retained earnings balance (December 31, 2003)
LG1
2–2
$50,200
42,900
( 20,000)
$73,100
Financial statement account identification Mark each of the accounts listed in
the following table as follows:
a. In column (1), indicate in which statement—income statement (IS) or balance
sheet (BS)—the account belongs.
78
PART 1
Introduction to Managerial Finance
b. In column (2), indicate whether the account is a current asset (CA), current
liability (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue
(R), or stockholders’ equity (SE).
Account name
Accounts payable
Accounts receivable
Accruals
Accumulated depreciation
Administrative expense
Buildings
Cash
Common stock (at par)
Cost of goods sold
Depreciation
Equipment
General expense
Interest expense
Inventories
Land
Long-term debts
Machinery
Marketable securities
Notes payable
Operating expense
Paid-in capital in excess of par
Preferred stock
Preferred stock dividends
Retained earnings
Sales revenue
Selling expense
Taxes
Vehicles
LG1
2–3
(1)
Statement
(2)
Type of account
Income statement preparation On December 31, 2003, Cathy Chen, a selfemployed certified public accountant (CPA), completed her first full year in business. During the year, she billed $180,000 for her accounting services. She had
two employees: a bookkeeper and a clerical assistant. In addition to her monthly
salary of $4,000, Ms. Chen paid annual salaries of $24,000 and $18,000 to the
bookkeeper and the clerical assistant, respectively. Employment taxes and benefit
costs for Ms. Chen and her employees totaled $17,300 for the year. Expenses for
office supplies, including postage, totaled $5,200 for the year. In addition, Ms.
Chen spent $8,500 during the year on tax-deductible travel and entertainment
associated with client visits and new business development. Lease payments for
CHAPTER 2
Financial Statements and Analysis
79
the office space rented (a tax-deductible expense) were $1,350 per month. Depreciation expense on the office furniture and fixtures was $7,800 for the year. During the year, Ms. Chen paid interest of $7,500 on the $60,000 borrowed to start
the business. She paid an average tax rate of 30 percent during 2003.
a. Prepare an income statement for Cathy Chen, CPA, for the year ended
December 31, 2003.
b. Evaluate her 2003 financial performance.
LG1
2–4
Calculation of EPS and retained earnings Philagem, Inc., ended 2003 with net
profit before taxes of $218,000. The company is subject to a 40% tax rate and
must pay $32,000 in preferred stock dividends before distributing any earnings
on the 85,000 shares of common stock currently outstanding.
a. Calculate Philagem’s 2003 earnings per share (EPS).
b. If the firm paid common stock dividends of $0.80 per share, how many dollars would go to retained earnings?
LG1
2–5
Balance sheet preparation Use the appropriate items from the following list to
prepare in good form Owen Davis Company’s balance sheet at December 31,
2003.
Item
Accounts payable
Accounts receivable
Accruals
Value ($000) at
December 31, 2003
$ 220
450
55
Accumulated depreciation
265
Buildings
225
Cash
215
Common stock (at par)
Cost of goods sold
Depreciation expense
Equipment
90
2,500
45
140
Furniture and fixtures
170
General expense
320
Inventories
375
Land
100
Long-term debts
420
Machinery
420
Marketable securities
Notes payable
75
475
Paid-in capital in excess of par
360
Preferred stock
100
Retained earnings
Sales revenue
Vehicles
210
3,600
25
80
PART 1
Introduction to Managerial Finance
LG1
2–6
Impact of net income on a firm’s balance sheet Conrad Air, Inc., reported net
income of $1,365,000 for the year ended December 31, 2003. Show the effect of
these funds on the firm’s balance sheet for the previous year (below) in each of
the scenarios following the balance sheet.
Conrad Air, Inc.
Balance Sheet
as of December 31, 2003
Assets
Liabilities and Stockholders’ Equity
Cash
$ 120,000
Marketable securities
35,000
Accounts receivable
45,000
Inventories
Current assets
Equipment
Buildings
Fixed assets
Total assets
130,000
$ 330,000
$2,970,000
1,600,000
$4,570,000
$4,900,000
Accounts payable
$
Short-term notes
55,000
$ 125,000
Current liabilities
Long-term debt
70,000
$2,700,000
$2,825,000
$ 500,000
Total liabilities
Common stock
Retained earnings
Stockholders’ equity
Total liabilities and equity
1,575,000
$2,075,000
$4,900,000
a. Conrad paid no dividends during the year and invested the funds in marketable securities.
b. Conrad paid dividends totaling $500,000 and used the balance of the net
income to retire (pay off) long-term debt.
c. Conrad paid dividends totaling $500,000 and invested the balance of the net
income in building a new hangar.
d. Conrad paid out all $1,365,000 as dividends to its stockholders.
LG1
2–7
Initial sale price of common stock Beck Corporation has one issue of preferred
stock and one issue of common stock outstanding. Given Beck’s stockholders’
equity account that follows, determine the original price per share at which the
firm sold its single issue of common stock.
Stockholders’ Equity ($000)
Preferred stock
Common stock ($0.75 par, 300,000 shares outstanding)
Paid-in capital in excess of par on common stock
Retained earnings
Total stockholders’ equity
LG1
2–8
$ 125
225
2,625
900
$3,875
Statement of retained earnings Hayes Enterprises began 2003 with a retained
earnings balance of $928,000. During 2003, the firm earned $377,000 after
taxes. From this amount, preferred stockholders were paid $47,000 in dividends. At year-end 2003, the firm’s retained earnings totaled $1,048,000. The
firm had 140,000 shares of common stock outstanding during 2003.
CHAPTER 2
Financial Statements and Analysis
81
a. Prepare a statement of retained earnings for the year ended December 31,
2003, for Hayes Enterprises. (Note: Be sure to calculate and include the
amount of cash dividends paid in 2003.)
b. Calculate the firm’s 2003 earnings per share (EPS).
c. How large a per-share cash dividend did the firm pay on common stock during 2003?
LG1
2–9
Changes in stockholders’ equity Listed are the equity sections of balance sheets
for years 2002 and 2003 as reported by Mountain Air Ski Resorts, Inc. The
overall value of stockholders’ equity has risen from $2,000,000 to $7,500,000.
Use the statements to discover how and why this happened.
Mountain Air Ski Resorts, Inc.
Balance Sheets (partial)
Stockholders’ Equity
2002
2003
Common stock ($1.00 par)
Authorized—5,000,000 shares
Outstanding— 1,500,000 shares 2003
—
500,000 shares 2002
$1,500,000
$ 500,000
Paid-in capital in excess of par
Retained earnings
Total stockholders’ equity
500,000
4,500,000
1,000,000
$2,000,000
1,500,000
$7,500,000
The company paid total dividends of $200,000 during fiscal 2003.
a. What was Mountain Air’s net income for fiscal 2003?
b. How many new shares did the corporation issue and sell during the
year?
c. At what average price per share did the new stock sold during 2003 sell?
d. At what price per share did Mountain Air’s original 500,000 shares sell?
LG2
LG3
LG4
LG5
2–10
Ratio comparisons Robert Arias recently inherited a stock portfolio from his
uncle. Wishing to learn more about the companies that he is now invested in,
Robert performs a ratio analysis on each one and decides to compare them to
each other. Some of his ratios are listed below.
Island
Electric Utility
Burger
Heaven
Fink
Software
Roland
Motors
Current ratio
1.10
1.3
6.8
4.5
Quick ratio
0.90
0.82
5.2
3.7
Debt ratio
0.68
0.46
0
Net profit margin
6.2%
14.3%
Ratio
28.5%
0.35
8.4%
Assuming that his uncle was a wise investor who assembled the portfolio with
care, Robert finds the wide differences in these ratios confusing. Help him out.
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Introduction to Managerial Finance
a. What problems might Robert encounter in comparing these companies to
one another on the basis of their ratios?
b. Why might the current and quick ratios for the electric utility and the
fast-food stock be so much lower than the same ratios for the other
companies?
c. Why might it be all right for the electric utility to carry a large amount of
debt, but not the software company?
d. Why wouldn’t investors invest all of their money in software companies
instead of in less profitable companies? (Focus on risk and return.)
LG3
2–11
Liquidity management Bauman Company’s total current assets, total current
liabilities, and inventory for each of the past 4 years follow:
Item
Total current assets
2000
2001
2002
2003
$16,950
$21,900
$22,500
$27,000
Total current liabilities
9,000
12,600
12,600
17,400
Inventory
6,000
6,900
6,900
7,200
a. Calculate the firm’s current and quick ratios for each year. Compare the
resulting time series for these measures of liquidity.
b. Comment on the firm’s liquidity over the 2000–2003 period.
c. If you were told that Bauman Company’s inventory turnover for each
year in the 2000–2003 period and the industry averages were as follows,
would this information support or conflict with your evaluation in part b?
Why?
Inventory turnover
2000
Bauman Company
Industry average
LG3
2–12
2001
2002
2003
6.3
6.8
7.0
6.4
10.6
11.2
10.8
11.0
Inventory management Wilkins Manufacturing has sales of $4 million and a
gross profit margin of 40%. Its end-of-quarter inventories are
Quarter
Inventory
1
$ 400,000
2
800,000
3
1,200,000
4
200,000
a. Find the average quarterly inventory and use it to calculate the firm’s inventory turnover and the average age of inventory.
b. Assuming that the company is in an industry with an average inventory
turnover of 2.0, how would you evaluate the activity of Wilkins’ inventory?
CHAPTER 2
LG3
2–13
Financial Statements and Analysis
83
Accounts receivable management An evaluation of the books of Blair Supply,
which follows, gives the end-of-year accounts receivable balance, which is
believed to consist of amounts originating in the months indicated. The company
had annual sales of $2.4 million. The firm extends 30-day credit terms.
Month of origin
Amounts receivable
July
$ 3,875
August
2,000
September
34,025
October
15,100
November
52,000
December
193,000
$300,000
Year-end accounts receivable
a. Use the year-end total to evaluate the firm’s collection system.
b. If 70% of the firm’s sales occur between July and December, would this
affect the validity of your conclusion in part a? Explain.
LG3
2–14
Interpreting liquidity and activity ratios The new owners of Bluegrass Natural
Foods, Inc., have hired you to help them diagnose and cure problems that the
company has had in maintaining adequate liquidity. As a first step, you perform
a liquidity analysis. You then do an analysis of the company’s short-term activity
ratios. Your calculations and appropriate industry norms are listed.
Ratio
Bluegrass
Industry norm
Current ratio
4.5
4.0
Quick ratio
2.0
3.1
Inventory turnover
6.0
10.4
Average collection period
73 days
52 days
Average payment period
31 days
40 days
a. What recommendations relative to the amount and the handling of inventory
could you make to the new owners?
b. What recommendations relative to amount and handling of accounts receivable could you make to the new owners?
c. What recommendations relative to amount and handling of accounts payable
could you make to the new owners?
d. What results, overall, would you hope your recommendations would
achieve? Why might your recommendations not be effective?
LG4
2–15
Debt analysis Springfield Bank is evaluating Creek Enterprises, which has
requested a $4,000,000 loan, to assess the firm’s financial leverage and financial
risk. On the basis of the debt ratios for Creek, along with the industry averages
and Creek’s recent financial statements (which follow), evaluate and recommend
appropriate action on the loan request.
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Introduction to Managerial Finance
Creek Enterprises
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$30,000,000
Less: Cost of goods sold
21,000,000
$ 9,000,000
Gross profits
Less: Operating expenses
Selling expense
$3,000,000
General and administrative expenses
Lease expense
1,800,000
200,000
Depreciation expense
1,000,000
Total operating expense
Operating profits
Less: Interest expense
6,000,000
$ 3,000,000
1,000,000
$ 2,000,000
Net profits before taxes
800,000
$ 1,200,000
Less: Taxes (rate = 40%)
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
100,000
$ 1,100,000
Creek Enterprises
Balance Sheet
December 31, 2003
Assets
Liabilities and Stockholders’ Equity
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets (at cost)a
Land and buildings
Machinery and equipment
Furniture and fixtures
Gross fixed assets
Less: Accumulated depreciation
Net fixed assets
Total assets
aThe
Current liabilities
$ 1,000,000
3,000,000
12,000,000
7,500,000
$23,500,000
$11,000,000
20,500,000
Accounts payable
$ 8,000,000
Notes payable
Accruals
Total current liabilities
Long-term debt (includes financial leases)b
Stockholders’ equity
8,000,000
500,000
$16,500,000
$20,000,000
Preferred stock (25,000 shares,
$4 dividend)
$ 2,500,000
8,000,000
$39,500,000
Common stock (1 million shares at $5 par)
5,000,000
Paid-in capital in excess of par value
4,000,000
13,000,000
$26,500,000
$50,000,000
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
2,000,000
$13,500,000
$50,000,000
firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three years of the lease have yet to run.
annual principal payments are $800,000.
bRequired
Note: Industry averages appear at the top of the following page.
CHAPTER 2
Financial Statements and Analysis
85
Industry averages
LG5
2–16
Debt ratio
0.51
Times interest earned ratio
7.30
Fixed-payment coverage ratio
1.85
Common-size statement analysis A common-size income statement for Creek
Enterprises’ 2002 operations follows. Using the firm’s 2003 income statement
presented in Problem 2–15, develop the 2003 common-size income statement
and compare it to the 2002 statement. Which areas require further analysis and
investigation?
Creek Enterprises
Common-size Income Statement
for the Year Ended December 31, 2002
Sales revenue ($35,000,000)
100.0%
Less: Cost of goods sold
65.9
34.1%
Gross profits
Less: Operating expenses
Selling expense
12.7%
General and administrative expenses
6.3
Lease expense
0.6
Depreciation expense
3
.6
Total operating expense
Operating profits
Less: Interest expense
1.5
9.4%
Net profits before taxes
Less: Taxes (rate 40%)
3.8
5.6%
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
LG4
LG5
2–17
23.2
10.9%
0.1
5.5%
The relationship between financial leverage and profitability Pelican Paper,
Inc., and Timberland Forest, Inc., are rivals in the manufacture of craft papers.
Some financial statement values for each company follow. Use them in a ratio
analysis that compares their financial leverage and profitability.
Item
Total assets
Pelican Paper, Inc.
Timberland Forest, Inc.
$10,000,000
$10,000,000
Total equity (all common)
9,000,000
5,000,000
Total debt
1,000,000
5,000,000
100,000
500,000
Annual interest
Total sales
$25,000,000
$25,000,000
EBIT
6,250,000
6,250,000
Net income
3,690,000
3,450,000
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PART 1
Introduction to Managerial Finance
a. Calculate the following debt and coverage ratios for the two companies.
Discuss their financial risk and ability to cover the costs in relation to each
other.
(1) Debt ratio
(2) Times interest earned ratio
b. Calculate the following profitability ratios for the two companies. Discuss
their profitability relative to each other.
(1) Operating profit margin
(2) Net profit margin
(3) Return on total assets
(4) Return on common equity
c. In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberland’s investors
undertake when they choose to purchase its stock instead of Pelican’s?
LG6
2–18
Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 in
fiscal year 2003. Some ratios for the company are listed below. Use this information to determine the dollar values of various income statement and balance
sheet accounts as requested.
McDougal Printing, Inc.
Year Ended December 31, 2003
Sales
$40,000,000
Gross profit margin
80%
Operating profit margin
35%
Net profit margin
8%
Return on total assets
16%
Return on common equity
20%
Total asset turnover
Average collection period
2
62.2 days
Calculate values for the following:
a. Gross profits
b. Cost of goods sold
c. Operating profits
d. Operating expenses
e. Earnings available for common stockholders
f. Total assets
g. Total common stock equity
h. Accounts receivable
LG6
2–19
Cross-sectional ratio analysis Use the following financial statements for Fox
Manufacturing Company for the year ended December 31, 2003, along with the
industry average ratios also given in what follows, to:
a. Prepare and interpret a complete ratio analysis of the firm’s 2003 operations.
b. Summarize your findings and make recommendations.
CHAPTER 2
Financial Statements and Analysis
Fox Manufacturing Company
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$600,000
Less: Cost of goods sold
460,000
$140,000
Gross profits
Less: Operating expenses
General and administrative expenses
$30,000
Depreciation expense
30,000
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes
Net profits after taxes (earnings available
for common stockholders)
Earnings per share (EPS)
60,000
$ 80,000
10,000
$ 70,000
27,100
$ 42,900
$2.15
Fox Manufacturing Company
Balance Sheet
December 31, 2003
Assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
$ 15,000
7,200
34,100
82,000
$138,300
$270,000
$408,300
Liabilities and Stockholders’ Equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Stockholders’ equity
$ 57,000
13,000
5,000
$ 75,000
$150,000
Common stock equity (20,000 shares outstanding)
$110,200
Retained earnings
73,100
$183,300
$408,300
Total stockholders’ equity
Total liabilities and stockholders’ equity
Note: Industry averages appear at the top of the following page.
87
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Introduction to Managerial Finance
Ratio
Industry average, 2003
Current ratio
Quick ratio
Inventory turnover a
Average collection perioda
Total asset turnover
Debt ratio
Times interest earned ratio
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets (ROA)
Return on common equity (ROE)
Earnings per share (EPS)
aBased
LG6
2–20
2.35
0.87
4.55
35.3 days
1.09
0.300
12.3
0.202
0.135
0.091
0.099
0.167
$3.10
on a 360-day year and on end-of-year figures.
Financial statement analysis The financial statements of Zach Industries for the
year ended December 31, 2003, follow.
Zach Industries
Income Statement
for the Year Ended December 31, 2003
Zach Industries
Balance Sheet
December 31, 2003
Sales revenue
$160,000
Less: Cost of goods sold
106,000
$ 54,000
Gross profits
Less: Operating expenses
Selling expense
General and administrative expenses
Lease expense
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes
Net profits after taxes
$ 16,000
10,000
1,000
10,000
$ 37,000
$ 17,000
6,100
$ 10,900
4,360
$ 6,540
Assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Land
Buildings and equipment
Less: Accumulated depreciation
Net fixed assets
Total assets
$
500
1,000
25,000
45,500
$ 72,000
$ 26,000
90,000
38,000
$ 78,000
$150,000
Liabilities and Stockholders’ Equity
Accounts payable
$ 22,000
Notes payable
Long-term debt
47,000
$ 69,000
$ 22,950
Common stocka
$ 31,500
Retained earnings
$ 26,550
$150,000
Total current liabilities
Total liabilities and stockholders’ equity
aThe
firm’s 3,000 outstanding shares of common stock closed
2003 at a price of $25 per share.
CHAPTER 2
Financial Statements and Analysis
89
a. Use the preceding financial statements to complete the following table.
Assume that the industry averages given in the table are applicable for both
2002 and 2003.
Ratio
Industry
average
Actual 2002
Actual 2003
Current ratio
Quick ratio
Inventory turnovera
Average collection perioda
Debt ratio
Times interest earned ratio
Gross profit margin
Net profit margin
Return on total assets
Return on common equity
Market/book ratio
1.80
0.70
2.50
37 days
65%
3.8
38%
3.5%
4.0%
9.5%
1.1
1.84
0.78
2.59
36 days
67%
4.0
40%
3.6%
4.0%
8.0%
1.2
aBased
on a 360-day year and on end-of-year figures.
b. Analyze Zach Industries’ financial condition as it is related to (1) liquidity,
(2) activity, (3) debt, (4) profitability, and (5) market. Summarize the company’s overall financial condition.
LG6
2–21
Integrative—Complete ratio analysis Given the following financial statements,
historical ratios, and industry averages, calculate Sterling Company’s financial
ratios for the most recent year. Analyze its overall financial situation from both
a cross-sectional and a time-series viewpoint. Break your analysis into evaluations of the firm’s liquidity, activity, debt, profitability, and market.
Sterling Company
Income Statement
for the Year Ended December 31, 2003
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses
Selling expense
General and administrative expenses
Lease expense
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate = 40%)
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
Earnings per share (EPS)
$10,000,000
7,500,000
$ 2,500,000
$300,000
650,000
50,000
200,000
1,200,000
$ 1,300,000
200,000
$ 1,100,000
440,000
$ 660,000
50,000
$ 610,000
$3.05
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PART 1
Introduction to Managerial Finance
Sterling Company
Balance Sheet
December 31, 2003
Assets
Liabilities and Stockholders’ Equity
Current assets
Current liabilities
Cash
$
200,000
Marketable securities
50,000
Accounts receivable
800,000
Inventories
950,000
$ 2,000,000
Total current assets
Gross fixed assets (at cost)a
$12,000,000
Less: Accumulated depreciation
3,000,000
Net fixed assets
Other assets
Total assets
Accounts payableb
$
900,000
Notes payable
200,000
Accruals
100,000
$ 1,200,000
$ 3,000,000
Total current liabilities
Long-term debt (includes financial leases)c
Stockholders’ equity
Preferred stock (25,000 shares, $2 dividend)
$ 9,000,000
Common stock (200,000 shares at $3 par)d
$ 1,000,000
$12,000,000
Paid-in capital in excess of par value
$ 1,000,000
600,000
5,200,000
Retained earnings
1,000,000
$ 7,800,000
$12,000,000
Total stockholders’ equity
Total liabilities and stockholders’ equity
aThe
firm has an 8-year financial lease requiring annual beginning-of-year payments of $50,000. Five years of the lease have yet to run.
credit purchases of $6,200,000 were made during the year.
cThe annual principal payment on the long-term debt is $100,000.
dOn December 31, 2003, the firm’s common stock closed at $39.50 per share.
bAnnual
Historical and Industry Average Ratios for Sterling Company
Ratio
Actual 2001
Actual 2002
Industry average, 2003
Current ratio
1.40
1.55
1.85
Quick ratio
1.00
0.92
1.05
Inventory turnover
9.52
9.21
8.60
Average collection period
45.0 days
36.4 days
35.0 days
Average payment period
58.5 days
60.8 days
45.8 days
Total asset turnover
0.74
0.80
0.74
Debt ratio
0.20
0.20
0.30
Times interest earned ratio
8.2
7.3
8.0
Fixed-payment coverage ratio
4.5
4.2
4.2
Gross profit margin
0.30
0.27
0.25
Operating profit margin
0.12
0.12
0.10
Net profit margin
0.062
0.062
0.053
Return on total assets (ROA)
0.045
0.050
0.040
Return on common equity (ROE)
0.061
0.067
0.066
Earnings per share (EPS)
$1.75
$2.20
$1.50
Price/earnings (P/E) ratio
12.0
10.5
11.2
Market/book (M/B) ratio
1.20
1.05
1.10
CHAPTER 2
LG6
2–22
Financial Statements and Analysis
91
Dupont system of analysis Use the following ratio information for Johnson
International and the industry averages for Johnson’s line of business to:
a. Construct the DuPont system of analysis for both Johnson and the
industry.
b. Evaluate Johnson (and the industry) over the 3-year period.
c. Indicate in which areas Johnson requires further analysis. Why?
2001
2002
2003
Financial leverage multiplier
1.75
1.75
1.85
Net profit margin
0.059
0.058
0.049
Total asset turnover
2.11
2.18
2.34
Financial leverage multiplier
1.67
1.69
1.64
Net profit margin
0.054
0.047
0.041
Total asset turnover
2.05
2.13
2.15
Johnson
Industry Averages
LG6
2–23
Complete ratio analysis, recognizing significant differences Home Health, Inc.,
has come to Jane Ross for a yearly financial checkup. As a first step, Jane has
prepared a complete set of ratios for fiscal years 2002 and 2003. She will use
them to look for significant changes in the company’s situation from one year to
the next.
Home Health, Inc.
Financial Ratios
Ratio
2002
2003
Current ratio
3.25
3.00
Quick ratio
2.50
2.20
Inventory turnover
12.80
10.30
Average collection period
42 days
31 days
Total asset turnover
1.40
2.00
Debt ratio
0.45
0.62
Times interest earned ratio
4.00
3.85
Gross profit margin
68%
65%
Operating profit margin
14%
16%
Net profit margin
8.3%
8.1%
Return on total assets
11.6%
16.2%
Return on common equity
21.1%
42.6%
Price/earnings ratio
10.7
Market/book ratio
1.40
9.8
1.25
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Introduction to Managerial Finance
a. In order to focus on the degree of change, calculate the year-to-year proportional change by subtracting the year 2002 ratio from the year 2003 ratio,
then dividing the difference by the year 2002 ratio. Multiply the result by
100. Preserve the positive or negative sign. The result is the percentage
change in the ratio from 2002 to 2003. Calculate the proportional change for
the ratios shown here.
b. For any ratio that shows a year-to-year difference of 10% or more, state
whether the difference is in the company’s favor or not.
c. For the most significant changes (25% or more), look at the other ratios and
cite at least one other change that may have contributed to the change in the
ratio that you are discussing.
CHAPTER 2 CASE
Assessing Martin Manufacturing’s
Current Financial Position
T
erri Spiro, an experienced budget analyst at Martin Manufacturing
Company, has been charged with assessing the firm’s financial performance
during 2003 and its financial position at year-end 2003. To complete this assignment, she gathered the firm’s 2003 financial statements, which follow. In addition, Terri obtained the firm’s ratio values for 2001 and 2002, along with the
2003 industry average ratios (also applicable to 2001 and 2002). These are presented in the table on page 94.
Martin Manufacturing Company
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$5,075,000
Less: Cost of goods sold
3,704,000
$1,371,000
Gross profits
Less: Operating expenses
Selling expense
General and administrative expenses
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate 40%)
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
Earnings per share (EPS)
$650,000
416,000
152,000
1,218,000
$ 153,000
93,000
$ 60,000
24,000
$ 36,000
3,000
$ 33,000
$0.33
CHAPTER 2
Financial Statements and Analysis
Martin Manufacturing Company
Balance Sheets
December 31
Assets
2003
2002
Current assets
Cash
$
Accounts receivable
Inventories
Total current assets
Gross fixed assets (at cost)
Less: Accumulated depreciation
Net fixed assets
Total assets
25,000
$
24,100
805,556
763,900
700,625
$1,531,181
$2,093,819
763,445
$1,551,445
$1,691,707
500,000
$1,593,819
$3,125,000
348,000
$1,343,707
$2,895,152
$ 230,000
$ 400,500
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Total liabilities
Stockholders’ equity
Preferred stock (2,500 shares, $1.20 dividend)
Common stock (100,000 shares at $4 par)a
Paid-in capital in excess of par value
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
311,000
370,000
75,000
$ 616,000
100,902
$ 871,402
$1,165,250
$1,781,250
$ 700,000
$1,571,402
$
$
50,000
400,000
50,000
400,000
593,750
593,750
300,000
$1,343,750
$3,125,000
280,000
$1,323,750
$2,895,152
aThe
firm’s 100,000 outstanding shares of common stock closed 2003 at a price of $11.38
per share.
Note: Industry historical ratios appear at the top of the following page.
93
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Martin Manufacturing Company
Historical ratios
Ratio
Actual
2001
Actual
2002
Current ratio
1.7
1.8
Quick ratio
1.0
0.9
Inventory turnover (times)
5.2
5.0
Average collection period
Total asset turnover (times)
50 days
55 days
1.5
1.5
45.8%
54.3%
2.2
1.9
27.5%
28.0%
Net profit margin
1.1%
1.0%
Return on total assets (ROA)
1.7%
1.5%
Return on common equity (ROE)
3.1%
3.3%
Debt ratio
Times interest earned ratio
Gross profit margin
Price/earnings (P/E) ratio
33.5
38.7
Market/book (M/B) ratio
1.0
1.1
Actual
2003
Industry average
2003
1.5
1.2
10.2
46 days
2.0
24.5%
2.5
26.0%
1.2%
2.4%
3.2%
43.4
1.2
Required
a. Calculate the firm’s 2003 financial ratios, and then fill in the preceding table.
b. Analyze the firm’s current financial position from both a cross-sectional and
a time-series viewpoint. Break your analysis into evaluations of the firm’s
liquidity, activity, debt, profitability, and market.
c. Summarize the firm’s overall financial position on the basis of your findings
in part b.
WEB EXERCISE
WW
W
Go to Web site www.yahoo.com. On the left side of the Yahoo! home page
screen, click on the Finance category under Business and Economy. On the next
screen click on Y! Finance.
Using this screen, click on Symbol Lookup and find the symbol for Southwest Airlines. Click on this symbol to find the latest trading data for Southwest
Airlines.
1. What was the selling price for the last sale of Southwest’s common stock?
How much in dollars per share was the change?
2. What was the number of shares sold in this trade?
In the More Info box, you will see Profile. Click on it, and scroll down to Statistics at a Glance.
3. What was the amount of Southwest’s sales? What was its after-tax income?
4. What were Southwest’s earnings per share? What was its book value per
share?
CHAPTER 2
Financial Statements and Analysis
95
5. How many shares of stock does Southwest have outstanding?
6. What were the values of the following ratios for Southwest?
a. Current ratio
b. Operating profit margin
c. Debt/equity ratio
d. Return on equity
e. What other information would you need to evaluate Southwest’s financial performance on the basis of these ratios?
7. Find More from Market Guide and click on Ratio Comparisons. Using these
data, summarize Southwest’s performance.
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
CHAPTER
3
CASH FLOW AND
FINANCIAL PLANNING
L E A R N I N G
LG1
LG2
LG3
Understand the effect of depreciation on the
firm’s cash flows, the depreciable value of an
asset, its depreciable life, and tax depreciation
methods.
Discuss the firm’s statement of cash flows, operating cash flow, and free cash flow.
Understand the financial planning process,
including long-term (strategic) financial plans and
short-term (operating) financial plans.
G O A L S
LG4
LG5
LG6
Discuss the cash-planning process and the
preparation, evaluation, and use of the cash
budget.
Explain the simplified procedures used to prepare
and evaluate the pro forma income statement
and the pro forma balance sheet.
Cite the weaknesses of the simplified approaches
to pro forma financial statement preparation and
the common uses of pro forma statements.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand how depreciation is used
for both tax and financial reporting purposes; how to develop
the statement of cash flows; the primacy of cash flows, rather
than accruals, in financial decision making; and how pro forma
financial statements are used within the firm.
Information systems: You need to understand the data that
must be kept to record depreciation for tax and financial reporting; the information needs for strategic and operating plans;
and what data are needed as inputs for cash-planning and
profit-planning modules.
Management: You need to understand the difference between
strategic and operating plans, and the role of each; the impor-
96
tance of focusing on the firm’s cash flows; and how use of pro
forma statements can head off trouble for the firm.
Marketing: You need to understand the central role that marketing plays in formulating the firm’s long-term, strategic plans,
and the importance of the sales forecast as the key input for
both cash planning and profit planning.
Operations: You need to understand how depreciation affects
the value of the firm’s plant assets; how the results of operations are captured in the statement of cash flows; that operations are monitored primarily in the firm’s short-term financial
plans; and the distinction between fixed and variable operating
costs.
BEST BUY
PLANNING THAT
“BEST BUY”
t’s tempting for companies to focus on
short-term profitability, especially when
Wall Street is watching earnings reports,
looking for any signs of weakness that
could send the stock plummeting. This
was the dilemma facing the executive
team at Best Buy, a specialty retailer of consumer electronics, home office equipment, entertainment software, and appliances. After four straight years of profits in this competitive retail business, revenues and quarterly earnings were falling as the economy started to downshift in fall
2000. On the planning boards was an expansion strategy that included acquiring the Musicland
chain, using Best Buy stock to do so. As the stock price fell, some top managers urged founder
and CEO Richard Schulze to retrench and focus on the chain’s over 400 existing stores.
Instead of putting Best Buy’s growth on hold, Schulze went forward as planned. He was convinced that this was the best long-term strategy for the company, which was financially sound.
Careful planning had given Best Buy a $1 billion “war chest,” so Schulze could buy Musicland with
cash and the assumption of its debt. Best Buy also bought a Seattle chain, Magnolia Hi-Fi, for
cash. Some company officers were concerned about buying Musicland when the company’s
stock price was down. “It doesn’t change why we think this is a good deal,” Schulze pointed out.
The acquisition was important to Best Buy’s future plans. Musicland, which also owned the
Sam Goody chain, had 1,300 stores. Most were smaller than the typical Best Buy “big-box” store.
Their mall and small-town locations brought a different customer base to the company, providing a
way to reach new types of customers and gain further leverage with suppliers.
Nor did the company neglect short-term planning. To boost productivity and reduce labor
costs during the downturn, Best Buy cut sales staff during off-peak hours. It found ways to
improve inventory management as well. With these plans in place, earnings were up in the fourth
quarter of 2000, and the company reported record sales and a 20 percent increase in gross margin.
Despite the risks involved in taking this aggressive path, Schulze is more concerned with positioning Best Buy for the future. Opening new stores means higher expenses in the short term. But
he is confident that he made the right decision in sticking with the company’s long-term strategy to
become the world’s biggest consumer electronics chain. “Acquisitions and new strategies need
to be developed even when the economy is a little soft,” says Schulze. “You have to keep investing
in yourself, and that’s what we’re doing.”
This chapter focuses on the concept of cash flows and their use in the financial planning
process.
I
97
98
PART 1
LG1
Introduction to Managerial Finance
LG2
3.1 Analyzing the Firm’s Cash Flow
Cash flow, the lifeblood of the firm, is the primary focus of the financial manager
both in managing day-to-day finances and in planning and making strategic decisions aimed at creation of shareholder value. An important factor affecting a
firm’s cash flow is depreciation (and any other noncash charges). From an
accounting perspective, a firm’s cash flows can be summarized in the statement of
cash flows, which was described in Chapter 2. From a strict financial perspective,
firms often focus on both operating cash flow, which is used in managerial decision making, and free cash flow, which is closely watched by participants in the
capital market. We begin our analysis of cash flow by considering the key aspects
of depreciation, which is closely related to the firm’s cash flow.
Depreciation
depreciation
The systematic charging of a
portion of the costs of fixed
assets against annual revenues
over time.
modified accelerated cost
recovery system (MACRS)
System used to determine the
depreciation of assets for tax
purposes.
Business firms are permitted for tax and financial reporting purposes to charge a
portion of the costs of fixed assets systematically against annual revenues. This
allocation of historical cost over time is called depreciation. For tax purposes, the
depreciation of business assets is regulated by the Internal Revenue Code. Because
the objectives of financial reporting are sometimes different from those of tax legislation, firms often use different depreciation methods for financial reporting
than those required for tax purposes. Tax laws are used to accomplish economic
goals such as providing incentives for business investment in certain types of
assets, whereas the objectives of financial reporting are of course quite different.
Keeping two different sets of records for these two different purposes is legal.
Depreciation for tax purposes is determined by using the modified accelerated
cost recovery system (MACRS); a variety of depreciation methods are available for
financial reporting purposes. Before we discuss the methods of depreciating an
asset, you must understand the depreciable value of an asset and the depreciable
life of an asset.
Depreciable Value of an Asset
Under the basic MACRS procedures, the depreciable value of an asset (the amount
to be depreciated) is its full cost, including outlays for installation.1 No adjustment
is required for expected salvage value.
EXAMPLE
Baker Corporation acquired a new machine at a cost of $38,000, with installation
costs of $2,000. Regardless of its expected salvage value, the depreciable value of
the machine is $40,000: $38,000 cost $2,000 installation cost.
Depreciable Life of an Asset
depreciable life
Time period over which an asset
is depreciated.
The time period over which an asset is depreciated—its depreciable life—can significantly affect the pattern of cash flows. The shorter the depreciable life, the
more quickly the cash flow created by the depreciation write-off will be received.
Given the financial manager’s preference for faster receipt of cash flows, a shorter
1. Land values are not depreciable. Therefore, to determine the depreciable value of real estate, the value of the land
is subtracted from the cost of real estate. In other words, only buildings and other improvements are depreciable.
CHAPTER 3
TABLE 3.1
Property class
(recovery period)
99
First Four Property Classes Under MACRS
Definition
3 years
Research equipment and certain special tools.
5 years
Computers, typewriters, copiers, duplicating equipment, cars, lightduty trucks, qualified technological equipment, and similar assets.
7 years
Office furniture, fixtures, most manufacturing equipment, railroad
track, and single-purpose agricultural and horticultural structures.
10 years
recovery period
The appropriate depreciable life
of a particular asset as
determined by MACRS.
Cash Flow and Financial Planning
Equipment used in petroleum refining or in the manufacture of
tobacco products and certain food products.
depreciable life is preferred to a longer one. However, the firm must abide by certain Internal Revenue Service (IRS) requirements for determining depreciable life.
These MACRS standards, which apply to both new and used assets, require the
taxpayer to use as an asset’s depreciable life the appropriate MACRS recovery
period.2 There are six MACRS recovery periods—3, 5, 7, 10, 15, and 20 years—
excluding real estate. It is customary to refer to the property classes, in accordance
with their recovery periods, as 3-, 5-, 7-, 10-, 15-, and 20-year property. The first
four property classes—those routinely used by business—are defined in Table 3.1.
Depreciation Methods
For financial reporting purposes, a variety of depreciation methods (straight-line,
double-declining balance, and sum-of-the-years’-digits3) can be used. For tax purposes, using MACRS recovery periods, assets in the first four property classes are
depreciated by the double-declining balance (200 percent) method, using the halfyear convention and switching to straight-line when advantageous. Although
tables of depreciation percentages are not provided by law, the approximate percentages (rounded to the nearest whole percent) written off each year for the first
four property classes are shown in Table 3.2. Rather than using the percentages
in the table, the firm can either use straight-line depreciation over the asset’s
recovery period with the half-year convention or use the alternative depreciation
system. For purposes of this text, we will use the MACRS depreciation percentages, because they generally provide for the fastest write-off and therefore the
best cash flow effects for the profitable firm.
Because MACRS requires use of the half-year convention, assets are assumed
to be acquired in the middle of the year, and therefore only one-half of the first
year’s depreciation is recovered in the first year. As a result, the final half-year of
depreciation is recovered in the year immediately following the asset’s stated
recovery period. In Table 3.2, the depreciation percentages for an n-year class
asset are given for n 1 years. For example, a 5-year asset is depreciated over 6
recovery years. The application of the tax depreciation percentages given in Table
3.2 can be demonstrated by a simple example.
2. An exception occurs in the case of assets depreciated under the alternative depreciation system. For convenience,
in this text we ignore the depreciation of assets under this system.
3. For a review of these depreciation methods as well as other aspects of financial reporting, see any recently published financial accounting text.
100
PART 1
Introduction to Managerial Finance
TABLE 3.2
Rounded Depreciation
Percentages by Recovery Year
Using MACRS for First Four
Property Classes
Percentage by recovery yeara
Recovery year
3 years
5 years
7 years
10 years
1
33%
20%
14%
10%
2
45
32
25
18
3
15
19
18
14
4
7
12
12
12
5
12
9
9
6
5
9
8
7
9
7
8
4
6
9
6
10
6
11
4
1
0
0
%
1
00
%
Totals
10
0%
10
0%
aThese
percentages have been rounded to the nearest whole percent to simplify calculations while retaining realism. To calculate the actual depreciation for tax purposes, be sure to apply the actual unrounded percentages or
directly apply double-declining balance (200%) depreciation using the halfyear convention.
EXAMPLE
Baker Corporation acquired, for an installed cost of $40,000, a machine having a
recovery period of 5 years. Using the applicable percentages from Table 3.2,
Baker calculates the depreciation in each year as follows:
Percentages
(from Table 3.2)
(2)
Depreciation
[(1) (2)]
(3)
Year
Cost
(1)
1
$40,000
2
40,000
32
12,800
3
40,000
19
7,600
4
40,000
12
4,800
5
40,000
12
4,800
6
40,000
5
1
0
0
%
Totals
20%
$ 8,000
2,000
$
4
0
,0
0
0
Column 3 shows that the full cost of the asset is written off over 6 recovery years.
Because financial managers focus primarily on cash flows, only tax depreciation methods will be utilized throughout this textbook.
CHAPTER 3
Cash Flow and Financial Planning
101
Developing the Statement of Cash Flows
The statement of cash flows, introduced in Chapter 2, summarizes the firm’s cash
flow over a given period of time. Before discussing the statement and its interpretation, we will review the cash flow through the firm and the classification of
inflows and outflows of cash.
Hint Remember that in
finance, cash is king. Income
statement profits are good, but
they don’t pay the bills, nor do
asset owners accept them in
place of cash.
FIGURE 3.1
The Firm’s Cash Flows
Figure 3.1 illustrates the firm’s cash flows. Note that marketable securities are
considered the same as cash because of their highly liquid nature. Both cash and
marketable securities represent a reservoir of liquidity that is increased by cash
Cash Flows
The firm’s cash flows
(1) Operating Flows
Accrued
Wages
Labor
Raw
Materials
(2) Investment Flows
Payment of Accruals
Accounts
Payable
Payment
of Credit
Purchases
Purchase
Fixed Assets
Sale
Depreciation
Work in
Process
Overhead
Expenses
Business
Interests
Finished
Goods
Purchase
Sale
Cash
and
Marketable
Securities
Operating (incl.
Depreciation) and
Interest Expense
(3) Financing Flows
Borrowing
Payment
Taxes
Repayment
Refund
Sales
Cash Sales
Sale of Stock
Repurchase of Stock
Payment of Cash Dividends
Accounts
Receivable
Collection of Credit Sales
Debt
(Short-Term and
Long-Term)
Equity
102
PART 1
Introduction to Managerial Finance
operating flows
Cash flows directly related to
sale and production of the firm’s
products and services.
investment flows
Cash flows associated with
purchase and sale of both fixed
assets and business interests.
financing flows
Cash flows that result from debt
and equity financing transactions; includes incurrence and
repayment of debt, cash inflow
from the sale of stock, and cash
outflows to pay cash dividends or
repurchase stock.
inflows and decreased by cash outflows. Also note that the firm’s cash flows can
be divided into (1) operating flows, (2) investment flows, and (3) financing flows.
The operating flows are cash inflows and outflows directly related to sale and
production of the firm’s products and services. Investment flows are cash flows
associated with purchase and sale of both fixed assets and business interests.
Clearly, purchase transactions would result in cash outflows, whereas sales transactions would generate cash inflows. The financing flows result from debt and
equity financing transactions. Incurring (or repaying) either short-term or longterm debt would result in a corresponding cash inflow (or outflow). Similarly, the
sale of stock would result in a cash inflow; the payment of cash dividends or
repurchase of stock would result in a financing outflow. In combination, the
firm’s operating, investment, and financing cash flows during a given period
affect the firm’s cash and marketable securities balances.
Classifying Inflows and Outflows of Cash
The statement of cash flows in effect summarizes the inflows and outflows of
cash during a given period. Table 3.3 classifies the basic inflows (sources) and
outflows (uses) of cash. For example, if a firm’s accounts payable increased by
$1,000 during the year, the change would be an inflow of cash. If the firm’s
inventory increased by $2,500, the change would be an outflow of cash.
A few additional points can be made with respect to the classification scheme
in Table 3.3:
noncash charge
An expense deducted on the
income statement but does not
involve the actual outlay of cash
during the period; includes
depreciation, amortization, and
depletion.
1. A decrease in an asset, such as the firm’s cash balance, is an inflow of cash,
because cash that has been tied up in the asset is released and can be used for
some other purpose, such as repaying a loan. On the other hand, an increase
in the firm’s cash balance is an outflow of cash, because additional cash is
being tied up in the firm’s cash balance.
2. Depreciation (like amortization and depletion) is a noncash charge—an expense that is deducted on the income statement but does not involve the
actual outlay of cash during the period. Because it shields the firm from taxes
by lowering taxable income, the noncash charge is considered a cash inflow.
From a strict accounting perspective, adding depreciation back to the firm’s
net profits after taxes gives cash flow from operations:
Cash flow from operations Net profits after taxes Depreciation and other noncash charges
TABLE 3.3
The Inflows and Outflows of Cash
Inflows (sources)
Outflows (uses)
Decrease in any asset
Increase in any asset
Increase in any liability
Decrease in any liability
Net profits after taxes
Net loss
Depreciation and other noncash charges
Dividends paid
Sale of stock
Repurchase or retirement of stock
(3.1)
CHAPTER 3
Cash Flow and Financial Planning
103
Note that a firm can have a net loss (negative net profits after taxes) and still
have positive cash flow from operations when depreciation (and other noncash charges) during the period are greater than the net loss. In the statement
of cash flows, net profits after taxes (or net losses) and depreciation (and
other noncash charges) are therefore treated as separate entries.
3. Because depreciation is treated as a separate cash inflow, only gross rather
than net changes in fixed assets appear on the statement of cash flows. This
treatment avoids the potential double counting of depreciation.
4. Direct entries of changes in retained earnings are not included on the statement of cash flows. Instead, entries for items that affect retained earnings
appear as net profits or losses after taxes and dividends paid.
Preparing the Statement of Cash Flows
The statement of cash flows for a given period is developed using the income
statement for the period, along with the beginning- and end-of-period balance
sheets. The income statement for the year ended December 31, 2003, and the
December 31 balance sheets for 2002 and 2003 for Baker Corporation are given
in Tables 3.4 and 3.5, respectively. The statement of cash flows for the year
TABLE 3.4
Baker Corporation Income
Statement ($000) for the
Year Ended December 31,
2003
Sales revenue
$1,700
Less: Cost of goods sold
1
,0
0
0
$
7
0
0
Gross profits
Less: Operating expenses
Selling expense
General and administrative expense
Lease expensea
Depreciation expense
Total operating expense
$
70
120
40
100
3
3
0
Earnings before interest and taxes (EBIT)
$ 370
Less: Interest expense
7
0
$ 300
Net profits before taxes
Less: Taxes (rate 40%)
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
Earnings per share (EPS)b
aLease
120
$ 180
1
0
$
1
7
0
$1.70
expense is shown here as a separate item rather than
included as interest expense as specified by the FASB for financialreporting purposes. The approach used here is consistent with taxreporting rather than financial-reporting procedures.
bCalculated by dividing the earnings available for common stockholders by the number of shares of common stock outstanding
($170,000 100,000 shares $1.70 per share).
104
PART 1
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TABLE 3.5
Baker Corporation Balance
Sheets ($000)
December 31
Assets
2003
2002
$ 400
$ 300
600
200
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets (at cost)
Land and buildings
400
500
6
0
0
$2,000
9
0
0
$1,900
$1,200
$1,050
Machinery and equipment
850
800
Furniture and fixtures
300
220
Vehicles
100
80
5
0
$2,500
5
0
$2,200
1,300
$
1
,2
0
0
$
3
,
2
0
0
1,200
$
1
,0
0
0
$
2
,
9
0
0
$ 700
$ 500
Other (includes certain leases)
Total gross fixed assets (at cost)
Less: Accumulated depreciation
Net fixed assets
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Total liabilities
Stockholders’ equity
Preferred stock
600
700
100
$1,400
200
$1,400
$ 00
6
$2,000
$
4
0
0
$1,800
$ 100
$ 100
Common stock—$1.20 par, 100,000 shares
outstanding in 2003 and 2002
120
120
Paid-in capital in excess of par on common stock
380
380
6
0
0
$1,200
$3,2
00
5
0
0
$1,100
$
2,9
00
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
ended December 31, 2003, for Baker Corporation is presented in Table 3.6.
Note that all cash inflows as well as net profits after taxes and depreciation are
treated as positive values. All cash outflows, any losses, and dividends paid are
treated as negative values. The items in each category—operating, investment,
and financing—are totaled, and the three totals are added to get the “Net
increase (decrease) in cash and marketable securities” for the period. As a
CHAPTER 3
TABLE 3.6
Cash Flow and Financial Planning
105
Baker Corporation Statement of
Cash Flows ($000) for the Year
Ended December 31, 2003
Cash Flow from Operating Activities
Net profits after taxes
Depreciation
$180
100
Decrease in accounts receivable
100
Decrease in inventories
300
Increase in accounts payable
Decrease in accruals
Cash provided by operating activities
200
( 100)a
$780
Cash Flow from Investment Activities
Increase in gross fixed assets
($300)
Changes in business interests
0
Cash provided by investment activities
( 300)
Cash Flow from Financing Activities
Decrease in notes payable
($100)
Increase in long-term debts
200
Changes in stockholders’ equityb
Dividends paid
Cash provided by financing activities
Net increase in cash and marketable securities
0
(8
0
)
20
$
5
00
aAs
is customary, parentheses are used to denote a negative number, which in this
case is a cash outflow.
bRetained earnings are excluded here, because their change is actually reflected in
the combination of the “Net profits after taxes” and “Dividends paid” entries.
check, this value should reconcile with the actual change in cash and marketable securities for the year, which is obtained from the beginning- and endof-period balance sheets.
Interpreting the Statement
The statement of cash flows allows the financial manager and other interested
parties to analyze the firm’s cash flow. The manager should pay special attention
both to the major categories of cash flow and to the individual items of cash
inflow and outflow, to assess whether any developments have occurred that are
contrary to the company’s financial policies. In addition, the statement can be
used to evaluate progress toward projected goals or to isolate inefficiencies. For
example, increases in accounts receivable or inventories resulting in major cash
outflows may signal credit or inventory problems, respectively. The financial
manager also can prepare a statement of cash flows developed from projected
financial statements. This approach can be used to determine whether planned
actions are desirable in view of the resulting cash flows.
An understanding of the basic financial principles presented throughout this
text is absolutely essential to the effective interpretation of the statement of
cash flows.
106
PART 1
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Operating Cash Flow
operating cash flow (OCF)
The cash flow a firm generates
from its normal operations;
calculated as EBIT taxes depreciation.
A firm’s operating cash flow (OCF) is the cash flow it generates from its normal
operations—producing and selling its output of goods or services. A variety of
definitions of OCF can be found in the financial literature. Equation 3.1 introduced the simple accounting definition of cash flow from operations. Here we
refine this definition to estimate cash flows more accurately. Unlike the earlier
definition, this one excludes interest and taxes in order to focus on the true cash
flow resulting from operations without regard to financing costs and taxes. Operating cash flow (OCF) is defined in Equation 3.2.
OCF EBIT Taxes Depreciation
EXAMPLE
(3.2)
Substituting the values for Baker Corporation from its income statement (Table
3.4) into Equation 3.2, we get
OCF $370 $120 $100 $350
Baker Corporation during 2003 generated $350,000 of cash flow from producing and selling its output. Because Baker’s operating cash flow is positive, we can
conclude that the firm’s operations are generating positive cash flows.
Comparing Equations 3.1 and 3.2 reveals that the key difference between the
accounting and finance definitions of operating cash flow is that the finance definition excludes interest as an operating flow, whereas the accounting definition
in effect includes it as an operating flow. In the unlikely case that a firm had no
interest expense, the accounting (Equation 3.1) and finance (Equation 3.2) definitions of operating cash flow would be the same.
Free Cash Flow
free cash flow (FCF)
The amount of cash flow
available to investors (creditors
and owners) after the firm has
met all operating needs and paid
for investments in net fixed
assets and net current assets.
The firm’s free cash flow (FCF) represents the amount of cash flow available to
investors—the providers of debt (creditors) and equity (owners)—after the firm
has met all operating needs and paid for investments in net fixed assets and net
current assets. It represents the summation of the net amount of cash flow available to creditors and owners during the period. Free cash flow can be defined by
Equation 3.3.
FCF OCF Net fixed asset investment (NFAI)
Net current asset investment (NCAI)
(3.3)
The net fixed asset investment (NFAI) can be calculated as shown in Equation 3.4.
NFAI Change in net fixed assets Depreciation
EXAMPLE
(3.4)
Using the Baker Corporation’s balance sheets in Table 3.5, we see that its change
in net fixed assets between 2002 and 2003 was $200 ($1,200 in 2003 $1,000
in 2002). Substituting this value and the $100 of depreciation for 2003 into
Equation 3.4, we get Baker’s net fixed asset investment (NFAI) for 2003:
NFAI $200 $100 $300
Baker Corporation therefore invested a net $300,000 in fixed assets during 2003.
This amount would, of course, represent a net cash outflow to acquire fixed
assets during 2003.
CHAPTER 3
Cash Flow and Financial Planning
107
Looking at Equation 3.4, we can see that if the depreciation during a year is less
than the decrease during that year in net fixed assets, the NFAI would be negative. A negative NFAI represents a net cash inflow attributable to the fact that the
firm sold more assets than it acquired during the year.
The net current asset investment (NCAI) represents the net investment made
by the firm in its current (operating) assets. “Net” refers to the difference
between current assets and spontaneous current liabilities, which typically
include accounts payable and accruals. Because they are a negotiated source of
short-term financing, notes payable are not included in the NCAI calculation.
Instead, they serve as a creditor claim on the firm’s free cash flow. Equation 3.5
shows the NCAI calculation.
NCAI Change in current assets Change in spontaneous
current liabilities (Accounts payable Accruals)
EXAMPLE
(3.5)
Looking at the Baker Corporation’s balance sheets for 2002 and 2003 in Table
3.5, we see that the change in current assets between 2002 and 2003 is $100
($2,000 in 2003 $1,900 in 2002). The difference between Baker’s accounts
payable plus accruals of $800 in 2003 ($700 in accounts payable $100 in
accruals) and of $700 in 2002 ($500 in accounts payable $200 in accruals) is
$100 ($800 in 2003 $700 in 2002). Substituting into Equation 3.5 the
change in current assets and the change in the sum of accounts payable plus
accruals for Baker Corporation, we get its 2003 NCAI:
NCAI $100 $100 $0
This means that during 2003 Baker Corporation made no investment ($0) in its
current assets net of spontaneous current liabilities.
Now we can substitute Baker Corporation’s 2003 operating cash flow (OCF)
of $350, its net fixed asset investment (NFAI) of $300, and its net current asset
investment (NCAI) of $0 into Equation 3.3 to find its free cash flow (FCF):
FCF $350 $300 $0 $50
We can see that during 2003 Baker generated $50,000 of free cash flow, which it
can use to pay its investors—creditors (payment of interest) and owners (payment of dividends). Thus, the firm generated adequate cash flow to cover all of
its operating costs and investments and had free cash flow available to pay
investors.
Further analysis of free cash flow is beyond the scope of this initial introduction to cash flow. Clearly, cash flow is the lifeblood of the firm. We next consider
various aspects of financial planning for cash flow and profit.
Review Questions
3–1
3–2
Briefly describe the first four modified accelerated cost recovery system
(MACRS) property classes and recovery periods. Explain how the depreciation percentages are determined by using the MACRS recovery
periods.
Describe the overall cash flow through the firm in terms of operating
flows, investments flows, and financing flows.
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Introduction to Managerial Finance
3–3
3–4
3–5
3–6
LG3
Explain why a decrease in cash is classified as a cash inflow (source) and
why an increase in cash is classified as a cash outflow (use) in preparing
the statement of cash flows.
Why is depreciation (as well as amortization and depletion) considered a
noncash charge? How do accountants estimate cash flow from operations?
Describe the general format of the statement of cash flows. How are cash
inflows differentiated from cash outflows on this statement?
From a strict financial perspective, define and differentiate between a
firm’s operating cash flow (OCF) and its free cash flow (FCF).
3.2 The Financial Planning Process
financial planning process
Planning that begins with longterm, or strategic, financial plans
that in turn guide the formulation
of short-term, or operating, plans
and budgets.
Financial planning is an important aspect of the firm’s operations because it provides road maps for guiding, coordinating, and controlling the firm’s actions to
achieve its objectives. Two key aspects of the financial planning process are cash
planning and profit planning. Cash planning involves preparation of the firm’s
cash budget. Profit planning involves preparation of pro forma statements. Both
the cash budget and the pro forma statements are useful for internal financial
planning; they also are routinely required by existing and prospective lenders.
The financial planning process begins with long-term, or strategic, financial
plans. These in turn guide the formulation of short-term, or operating, plans and
budgets. Generally, the short-term plans and budgets implement the firm’s longterm strategic objectives. Although the remainder of this chapter places primary
emphasis on short-term financial plans and budgets, a few preliminary comments
on long-term financial plans are in order.
Long-Term (Strategic) Financial Plans
long-term (strategic)
financial plans
Lay out a company’s planned
financial actions and the anticipated impact of those actions
over periods ranging from 2 to 10
years.
Long-term (strategic) financial plans lay out a company’s planned financial
actions and the anticipated impact of those actions over periods ranging from 2
to 10 years. Five-year strategic plans, which are revised as significant new information becomes available, are common. Generally, firms that are subject to high
degrees of operating uncertainty, relatively short production cycles, or both, tend
to use shorter planning horizons.
Long-term financial plans are part of an integrated strategy that, along with
production and marketing plans, guides the firm toward strategic goals. Those
long-term plans consider proposed outlays for fixed assets, research and development activities, marketing and product development actions, capital structure,
and major sources of financing. Also included would be termination of existing
projects, product lines, or lines of business; repayment or retirement of outstanding debts; and any planned acquisitions. Such plans tend to be supported by a
series of annual budgets and profit plans.
Short-Term (Operating) Financial Plans
short-term (operating)
financial plans
Specify short-term financial
actions and the anticipated
impact of those actions.
Short-term (operating) financial plans specify short-term financial actions and the
anticipated impact of those actions. These plans most often cover a 1- to 2-year
period. Key inputs include the sales forecast and various forms of operating and
financial data. Key outputs include a number of operating budgets, the cash bud-
CHAPTER 3
FIGURE 3.2
Cash Flow and Financial Planning
109
Short-Term Financial Planning
The short-term (operating) financial planning process
Information Needed
Sales
Forecast
Output for Analysis
Production
Plans
Long-Term
Financing
Plan
Pro Forma
Income
Statement
Cash
Budget
Fixed Asset
Outlay
Plan
CurrentPeriod
Balance
Sheet
Pro Forma
Balance Sheet
Hint Electronic
spreadsheets such as Excel and
Lotus 1–2–3 are widely used to
streamline the process of
preparing and evaluating these
short-term financial planning
statements.
get, and pro forma financial statements. The entire short-term financial planning
process is outlined in Figure 3.2.
Short-term financial planning begins with the sales forecast. From it, production plans are developed that take into account lead (preparation) times and
include estimates of the required raw materials. Using the production plans, the
firm can estimate direct labor requirements, factory overhead outlays, and operating expenses. Once these estimates have been made, the firm’s pro forma
income statement and cash budget can be prepared. With the basic inputs (pro
forma income statement, cash budget, fixed asset outlay plan, long-term financing plan, and current-period balance sheet), the pro forma balance sheet can
finally be developed.
Throughout the remainder of this chapter, we will concentrate on the key
outputs of the short-term financial planning process: the cash budget, the pro
forma income statement, and the pro forma balance sheet.
Review Questions
3–7
3–8
What is the financial planning process? Contrast long-term (strategic)
financial plans and short-term (operating) financial plans.
Which three statements result as part of the short-term (operating) financial planning process?
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LG4
3.3 Cash Planning: Cash Budgets
cash budget (cash forecast)
A statement of the firm’s planned
inflows and outflows of cash that
is used to estimate its short-term
cash requirements.
The cash budget, or cash forecast, is a statement of the firm’s planned inflows and
outflows of cash. It is used by the firm to estimate its short-term cash requirements,
with particular attention to planning for surplus cash and for cash shortages.
Typically, the cash budget is designed to cover a 1-year period, divided into
smaller time intervals. The number and type of intervals depend on the nature
of the business. The more seasonal and uncertain a firm’s cash flows, the
greater the number of intervals. Because many firms are confronted with a seasonal cash flow pattern, the cash budget is quite often presented on a monthly
basis. Firms with stable patterns of cash flow may use quarterly or annual time
intervals.
The Sales Forecast
sales forecast
The prediction of the firm’s sales
over a given period, based on
external and/or internal data;
used as the key input to the
short-term financial planning
process.
external forecast
A sales forecast based on the
relationships observed between
the firm’s sales and certain key
external economic indicators.
internal forecast
A sales forecast based on a
buildup, or consensus, of sales
forecasts through the firm’s own
sales channels.
Hint The firm needs to
spend a great deal of time and
effort to make the sales forecast
as precise as possible. An
“after-the-fact” analysis of the
prior year’s forecast can help
the firm determine which
approach or combination of
approaches will give it the most
accurate forecasts.
The key input to the short-term financial planning process is the firm’s sales
forecast. This prediction of the firm’s sales over a given period is ordinarily prepared by the marketing department. On the basis of the sales forecast, the financial manager estimates the monthly cash flows that will result from projected
sales receipts and from outlays related to production, inventory, and sales. The
manager also determines the level of fixed assets required and the amount of
financing, if any, needed to support the forecast level of sales and production. In
practice, obtaining good data is the most difficult aspect of forecasting.4 The
sales forecast may be based on an analysis of external data, internal data, or a
combination of the two.
An external forecast is based on the relationships observed between the
firm’s sales and certain key external economic indicators such as the gross
domestic product (GDP), new housing starts, consumer confidence, and disposable personal income. Forecasts containing these indicators are readily available.
Because the firm’s sales are often closely related to some aspect of overall
national economic activity, a forecast of economic activity should provide insight
into future sales.
Internal forecasts are based on a buildup, or consensus, of sales forecasts
through the firm’s own sales channels. Typically, the firm’s salespeople in the
field are asked to estimate how many units of each type of product they expect to
sell in the coming year. These forecasts are collected and totaled by the sales manager, who may adjust the figures using knowledge of specific markets or of the
salesperson’s forecasting ability. Finally, adjustments may be made for additional
internal factors, such as production capabilities.
Firms generally use a combination of external and internal forecast data to
make the final sales forecast. The internal data provide insight into sales expectations, and the external data provide a means of adjusting these expectations to
take into account general economic factors. The nature of the firm’s product also
often affects the mix and types of forecasting methods used.
4. Calculation of the various forecasting techniques, such as regression, moving averages, and exponential smoothing, is not included in this text. For a description of the technical side of forecasting, refer to a basic statistics, econometrics, or management science text.
CHAPTER 3
TABLE 3.7
111
Cash Flow and Financial Planning
The General Format of the Cash Budget
Jan.
Feb.
Cash receipts
$XXX
$XXG
Less: Cash disbursements
X
X
A
$XXB
X
X
H
$XXI
...
XXC
$XXD
XXD
$XXJ
X
X
E
X
X
K
$XXL
Net cash flow
Add: Beginning cash
Ending cash
Less: Minimum cash balance
Required total financing
Excess cash balance
$XXF
...
Nov.
Dec.
$XXM
$XXT
X
X
N
$XXO
X
X
U
$XXV
XXJ
XXP
$XXQ
XXQ
$XXW
...
X
X
R
$XXS
X
X
Y
$XXZ
Preparing the Cash Budget
The general format of the cash budget is presented in Table 3.7. We will discuss
each of its components individually.
Cash Receipts
cash receipts
All of a firm’s inflows of cash in a
given financial period.
EXAMPLE
Cash receipts include all of a firm’s inflows of cash in a given financial period.
The most common components of cash receipts are cash sales, collections of
accounts receivable, and other cash receipts.
Coulson Industries, a defense contractor, is developing a cash budget for October, November, and December. Coulson’s sales in August and September were
$100,000 and $200,000, respectively. Sales of $400,000, $300,000, and
$200,000 have been forecast for October, November, and December, respectively. Historically, 20% of the firm’s sales have been for cash, 50% have generated accounts receivable collected after 1 month, and the remaining 30% have
generated accounts receivable collected after 2 months. Bad-debt expenses
(uncollectible accounts) have been negligible.5 In December, the firm will receive
a $30,000 dividend from stock in a subsidiary. The schedule of expected cash
receipts for the company is presented in Table 3.8. It contains the following items:
Forecast sales This initial entry is merely informational. It is provided as an
aid in calculating other sales-related items.
Cash sales The cash sales shown for each month represent 20% of the total
sales forecast for that month.
Collections of A/R These entries represent the collection of accounts receivable (A/R) resulting from sales in earlier months.
5. Normally, it would be expected that the collection percentages would total slightly less than 100%, because some
of the accounts receivable would be uncollectible. In this example, the sum of the collection percentages is 100%
(20% 50% 30%), which reflects the fact that all sales are assumed to be collected.
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TABLE 3.8
A Schedule of Projected Cash Receipts
for Coulson Industries ($000)
Forecast sales
Aug.
$100
Sept.
$200
Oct.
$400
Nov.
$300
Dec.
$200
Cash sales (0.20)
$20
$40
$ 80
$ 60
$ 40
50
100
200
150
30
60
120
$2
1
0
$
3
2
0
3
0
$
3
4
0
Collections of A/R:
Lagged 1 month (0.50)
Lagged 2 months (0.30)
Other cash receipts
Total cash receipts
Lagged 1 month These figures represent sales made in the preceding
month that generated accounts receivable collected in the current month.
Because 50% of the current month’s sales are collected 1 month later, the collections of A/R with a 1-month lag shown for September represent 50% of
the sales in August, collections for October represent 50% of September
sales, and so on.
Lagged 2 months These figures represent sales made 2 months earlier
that generated accounts receivable collected in the current month. Because
30% of sales are collected 2 months later, the collections with a 2-month lag
shown for October represent 30% of the sales in August, and so on.
Other cash receipts These are cash receipts expected from sources other
than sales. Interest received, dividends received, proceeds from the sale of
equipment, stock and bond sale proceeds, and lease receipts may show up
here. For Coulson Industries, the only other cash receipt is the $30,000 dividend due in December.
Total cash receipts This figure represents the total of all the cash receipts
listed for each month. For Coulson Industries, we are concerned only with
October, November, and December, as shown in Table 3.8.
Cash Disbursements
cash disbursements
All outlays of cash by the firm
during a given financial period.
Cash disbursements include all outlays of cash by the firm during a given financial period. The most common cash disbursements are
Cash purchases
Payments of accounts payable
Rent (and lease) payments
Wages and salaries
Tax payments
Fixed-asset outlays
Interest payments
Cash dividend payments
Principal payments (loans)
Repurchases or retirements of stock
It is important to recognize that depreciation and other noncash charges are
NOT included in the cash budget, because they merely represent a scheduled
write-off of an earlier cash outflow. The impact of depreciation, as we noted earlier, is reflected in the reduced cash outflow for tax payments.
CHAPTER 3
FOCUS ON PRACTICE
Cash Forecasts Needed, “Rain or Shine”
Given the importance of cash to
sound financial management, it is
surprising how many companies
ignore the cash-forecasting process. Three reasons come up most
often: Cash forecasts are always
wrong, they’re hard to do, and
managers don’t see the benefits of
these forecasts unless the company is already in a cash crunch. In
addition, each company has its
own methodology for cash forecasting. If the firm’s cash inflows
and outflows don’t form a pattern
that managers can graph, it’s tough
to develop successful forecasts.
Yet the reasons to forecast
cash are equally compelling: Cash
forecasts provide for reliable liquidity, enable a company to minimize borrowing costs or maximize
investment income, and help
financial executives manage currency exposures more accurately.
In times of tight credit, lenders
EXAMPLE
Cash Flow and Financial Planning
expect borrowers to monitor cash
carefully and will favor a company
that prepares good cash forecasts. When cash needs and the
forecasted cash position don’t
match, financial managers can
plan for borrowed funds to close
the gap.
New York City–based men’s
apparel manufacturer Salant Corp.
closely integrates its financial
plans and forecasts. “Our biggest
challenge is to keep the cash forecast and the projected profit and
loss in sync with the balance sheet
and vice versa,” says William R.
Bennett, vice president and treasurer. “We learned that the hard
way and developed our own
spreadsheet-based model.”
Although complicated to build, the
model is easy for managers to use.
Salant is a capital-intensive
operation, so its liquidity is linked
to its assets. Bennett uses the
113
In Practice
forecast of inventory and receivables as the forecast for borrowing
capacity required to meet its operating needs.
Like Salant, many companies
are using technology to demystify
cash forecasts. Software can apply
statistical techniques, graph historical data, or build models based on
each customer’s payment patterns.
It can also tap corporate databases
for the firm’s purchases and associated payment information and
order shipments to customers and
the associated payment terms.
These data increase forecast
accuracy.
Sources: Adapted from Richard H. Gamble,
“Cash Forecast: Cloudy But Clearing,” Business Finance (May 2001), downloaded from
www.businessfinancemag.com; “Profile:
Salant Corp.,” Yahoo! Finance, www.biz.
yahoo.com, downloaded November 19, 2001.
Coulson Industries has gathered the following data needed for the preparation of
a cash disbursements schedule for October, November, and December.
Purchases The firm’s purchases represent 70% of sales. Of this amount,
10% is paid in cash, 70% is paid in the month immediately following the
month of purchase, and the remaining 20% is paid 2 months following the
month of purchase.6
Rent payments Rent of $5,000 will be paid each month.
Wages and salaries Fixed salary cost for the year is $96,000, or $8,000 per
month. In addition, wages are estimated as 10% of monthly sales.
Tax payments Taxes of $25,000 must be paid in December.
Fixed-asset outlays New machinery costing $130,000 will be purchased
and paid for in November.
Interest payments
An interest payment of $10,000 is due in December.
6. Unlike the collection percentages for sales, the total of the payment percentages should equal 100%, because it is
expected that the firm will pay off all of its accounts payable.
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Cash dividend payments Cash dividends of $20,000 will be paid in October.
Principal payments (loans) A $20,000 principal payment is due in December.
Repurchases or retirements of stock No repurchase or retirement of stock is
expected between October and December.
The firm’s cash disbursements schedule, using the preceding data, is shown in
Table 3.9. Some items in the table are explained in greater detail below.
Purchases This entry is merely informational. The figures represent 70% of
the forecast sales for each month. They have been included to facilitate calculation of the cash purchases and related payments.
Cash purchases The cash purchases for each month represent 10% of the
month’s purchases.
Payments of A/P These entries represent the payment of accounts payable
(A/P) resulting from purchases in earlier months.
Lagged 1 month These figures represent purchases made in the preceding month that are paid for in the current month. Because 70% of the firm’s
purchases are paid for 1 month later, the payments with a 1-month lag
shown for September represent 70% of the August purchases, payments for
October represent 70% of September purchases, and so on.
Lagged 2 months These figures represent purchases made 2 months earlier that are paid for in the current month. Because 20% of the firm’s purchases are paid for 2 months later, the payments with a 2-month lag for
October represent 20% of the August purchases, and so on.
TABLE 3.9
A Schedule of Projected Cash
Disbursements for Coulson
Industries ($000)
Purchases (0.70 sales)
Cash purchases (0.10)
Aug.
$70
Sept.
$140
Oct.
$280
Nov.
$210
Dec.
$140
$7
$14
$ 28
$ 21
$ 14
98
196
147
14
28
56
Payments of A/P:
Lagged 1 month (0.70)
Lagged 2 months (0.20)
Rent payments
Wages and salaries
49
5
5
5
48
38
28
Tax payments
25
Fixed-asset outlays
130
Interest payments
Cash dividend payments
Principal payments
Total cash disbursements
10
20
$2
13
$
41
8
2
0
$
3
0
5
CHAPTER 3
Cash Flow and Financial Planning
115
Wages and salaries These amounts were obtained by adding $8,000 to
10% of the sales in each month. The $8,000 represents the salary component; the rest represents wages.
The remaining items on the cash disbursements schedule are self-explanatory.
net cash flow
The mathematical difference
between the firm’s cash
receipts and its cash disbursements in each period.
ending cash
The sum of the firm’s beginning
cash and its net cash flow for the
period.
required total financing
Amount of funds needed by the
firm if the ending cash for the
period is less than the desired
minimum cash balance; typically
represented by notes payable.
EXAMPLE
excess cash balance
The (excess) amount available
for investment by the firm if the
period’s ending cash is greater
than the desired minimum cash
balance; assumed to be invested
in marketable securities.
Net Cash Flow, Ending Cash, Financing, and Excess Cash
Look back at the general-format cash budget in Table 3.7. We have inputs for the
first two entries, and we now continue calculating the firm’s cash needs. The
firm’s net cash flow is found by subtracting the cash disbursements from cash
receipts in each period. Then we add beginning cash to the firm’s net cash flow to
determine the ending cash for each period. Finally, we subtract the desired minimum cash balance from ending cash to find the required total financing or the
excess cash balance. If the ending cash is less than the minimum cash balance,
financing is required. Such financing is typically viewed as short-term and is
therefore represented by notes payable. If the ending cash is greater than the minimum cash balance, excess cash exists. Any excess cash is assumed to be invested
in a liquid, short-term, interest-paying vehicle—that is, in marketable securities.
Table 3.10 presents Coulson Industries’ cash budget, based on the data already
developed. At the end of September, Coulson’s cash balance was $50,000, and its
notes payable and marketable securities equaled $0.7 The company wishes to
maintain, as a reserve for unexpected needs, a minimum cash balance of $25,000.
TABLE 3.10
A Cash Budget for Coulson
Industries ($000)
Oct.
Nov.
Dec.
$210
$320
$340
213
($ 3)
418
($ 98)
305
$ 35
5
0
$ 47
4
7
($ 51)
(5
1
)
($ 16)
Required total financing (notes payable)c
2
5
—
2
5
$ 76
2
5
$ 41
Excess cash balance (marketable securities)d
$ 22
—
—
Total cash receiptsa
Less: Total cash
disbursementsb
Net cash flow
Add: Beginning cash
Ending cash
Less: Minimum cash balance
aFrom
Table 3.8.
Table 3.9.
cValues are placed in this line when the ending cash is less than the desired minimum cash
balance. These amounts are typically financed short-term and therefore are represented by
notes payable.
dValues are placed in this line when the ending cash is greater than the desired minimum
cash balance. These amounts are typically assumed to be invested short-term and therefore are represented by marketable securities.
bFrom
7. If Coulson either had outstanding notes payable or held marketable securities at the end of September, its “beginning cash” value would be misleading. It could be either overstated or understated, depending on whether the firm
had notes payable or marketable securities on its books at that time. For simplicity, the cash budget discussions and
problems presented in this chapter assume that the firm’s notes payable and marketable securities equal $0 at the
beginning of the period of concern.
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For Coulson Industries to maintain its required $25,000 ending cash balance,
it will need total borrowing of $76,000 in November and $41,000 in December.
In October the firm will have an excess cash balance of $22,000, which can be
held in an interest-earning marketable security. The required total financing
figures in the cash budget refer to how much will be owed at the end of the
month; they do not represent the monthly changes in borrowing.
The monthly changes in borrowing and in excess cash can be found by further analyzing the cash budget. In October the $50,000 beginning cash, which
becomes $47,000 after the $3,000 net cash outflow, results in a $22,000 excess
cash balance once the $25,000 minimum cash is deducted. In November the
$76,000 of required total financing resulted from the $98,000 net cash outflow
less the $22,000 of excess cash from October. The $41,000 of required total
financing in December resulted from reducing November’s $76,000 of required
total financing by the $35,000 of net cash inflow during December. Summarizing, the financial activities for each month would be as follows:
Hint Not only is the cash
budget a great tool to let management know when it has cash
shortages or excesses, but it
may be a document required by
potential creditors. It communicates to them what the money
is going to be used for, and
how and when their loan will
be repaid.
October:
Invest the $22,000 excess cash balance in marketable securities.
November:
Liquidate the $22,000 of marketable securities and borrow
$76,000 (notes payable).
December:
Repay $35,000 of notes payable to leave $41,000 of outstanding required total financing.
Evaluating the Cash Budget
The cash budget indicates whether a cash shortage or surplus is expected in each
of the months covered by the forecast. Each month’s figure is based on the internally imposed requirement of a minimum cash balance and represents the total
balance at the end of the month.
At the end of each of the 3 months, Coulson expects the following balances
in cash, marketable securities, and notes payable:
End-of-month
balance ($000)
Account
Oct.
Nov.
Dec.
Cash
$25
$25
$25
22
0
0
0
76
41
Marketable securities
Notes payable
Hint Because of the
uncertainty of the ending cash
values, the financial manager
will usually seek to borrow
more than the maximum
financing indicated in the cash
budget.
Note that the firm is assumed first to liquidate its marketable securities to meet
deficits and then to borrow with notes payable if additional financing is needed.
As a result, it will not have marketable securities and notes payable on its books
at the same time.
Because it may be necessary to borrow up to $76,000 for the 3-month
period, the financial manager should be certain that some arrangement is made to
ensure the availability of these funds.
CHAPTER 3
117
Cash Flow and Financial Planning
Coping with Uncertainty in the Cash Budget
Aside from careful estimation of cash budget inputs, there are two ways of coping with the uncertainty of the cash budget.8 One is to prepare several cash budgets—based on pessimistic, most likely, and optimistic forecasts. From this range
of cash flows, the financial manager can determine the amount of financing necessary to cover the most adverse situation. The use of several cash budgets,
based on differing assumptions, also should give the financial manager a sense of
the riskiness of various alternatives. This sensitivity analysis, or “what if”
approach, is often used to analyze cash flows under a variety of circumstances.
Computers and electronic spreadsheets simplify the process of performing sensitivity analysis.
EXAMPLE
TABLE 3.11
Table 3.11 presents the summary of Coulson Industries’ cash budget prepared for
each month of concern using pessimistic, most likely, and optimistic estimates of
total cash receipts and disbursements. The most likely estimate is based on the
expected outcomes presented earlier.
During October, Coulson will, at worst, need a maximum of $15,000 of
financing and, at best, will have a $62,000 excess cash balance. During November, its financing requirement will be between $0 and $185,000, or it could
experience an excess cash balance of $5,000. The December projections show
maximum borrowing of $190,000 with a possible excess cash balance of
A Sensitivity Analysis of Coulson Industries’ Cash Budget ($000)
October
Total cash
receipts
Less: Total cash
disbursements
Net cash flow
Add: Beginning
cash
Ending cash
Less: Minimum
cash balance
Required total
financing
Excess cash
balance
November
December
Pessimistic
Most
likely
Optimistic
Pessimistic
Most
likely
Optimistic
Pessimistic
Most
likely
Optimistic
$160
$210
$285
$210
$320
$ 410
$275
$340
$422
2
0
0
($ 40)
2
1
3
($ 3)
2
4
8
$ 37
3
8
0
($170)
4
1
8
($ 98)
4
6
7
($ 57)
2
8
0
($ 5)
3
0
5
$ 35
3
2
0
$102
5
0
$ 10
5
0
$ 47
5
0
$ 87
1
0
($160)
4
7
($ 51)
8
7
$ 30
(1
6
0
)
($165)
(5
1
)
($ 16)
3
0
$132
2
5
2
5
2
5
2
5
2
5
2
5
2
5
2
5
2
5
$ 15
—
—
$185
$ 76
—
$190
$ 41
—
—
$ 22
$ 62
—
—
5
—
—
$107
$
8. The term uncertainty is used here to refer to the variability of the cash flow outcomes that may actually occur.
118
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Introduction to Managerial Finance
$107,000. By considering the extreme values in the pessimistic and optimistic
outcomes, Coulson Industries should be better able to plan its cash requirements.
For the 3-month period, the peak borrowing requirement under the worst circumstances would be $190,000, which happens to be considerably greater than
the most likely estimate of $76,000 for this period.
A second and much more sophisticated way of coping with uncertainty in the
cash budget is simulation (discussed in Chapter 10). By simulating the occurrence
of sales and other uncertain events, the firm can develop a probability distribution of its ending cash flows for each month. The financial decision maker can
then use the probability distribution to determine the amount of financing needed
to protect the firm adequately against a cash shortage.
Cash Flow Within the Month
WW
W
Because the cash budget shows cash flows only on a total monthly basis, the
information provided by the cash budget is not necessarily adequate for ensuring
solvency. A firm must look more closely at its pattern of daily cash receipts and
cash disbursements to ensure that adequate cash is available for paying bills as
they come due. For an example related to this topic, see the book’s Web site at
www.aw.com/gitman.
The synchronization of cash flows in the cash budget at month-end does not
ensure that the firm will be able to meet daily cash requirements. Because a firm’s
cash flows are generally quite variable when viewed on a daily basis, effective
cash planning requires a look beyond the cash budget. The financial manager
must therefore plan and monitor cash flow more frequently than on a monthly
basis. The greater the variability of cash flows from day to day, the greater the
attention required.
Review Questions
3–9
3–10
3–11
3–12
LG5
What is the purpose of the cash budget? What role does the sales forecast
play in its preparation?
Briefly describe the basic format of the cash budget.
How can the two “bottom lines” of the cash budget be used to determine
the firm’s short-term borrowing and investment requirements?
What is the cause of uncertainty in the cash budget, and what two techniques can be used to cope with this uncertainty?
3.4 Profit Planning: Pro Forma Statements
pro forma statements
Projected, or forecast, income
statements and balance sheets.
Whereas cash planning focuses on forecasting cash flows, profit planning relies
on accrual concepts to project the firm’s profit and overall financial position.
Shareholders, creditors, and the firm’s management pay close attention to the pro
forma statements, which are projected, or forecast, income statements and bal-
CHAPTER 3
Hint A key point in understanding pro forma statements
is that they reflect the goals and
objectives of the firm for the
planning period. In order for
these goals and objectives to be
achieved, operational plans
will have to be developed. Financial plans can be realized
only if the correct actions are
implemented.
Cash Flow and Financial Planning
119
ance sheets. The basic steps in the short-term financial planning process were
shown in the flow diagram of Figure 3.2. Various approaches for estimating the
pro forma statements are based on the belief that the financial relationships
reflected in the firm’s past financial statements will not change in the coming
period. The commonly used simplified approaches are presented in subsequent
discussions.
Two inputs are required for preparing pro forma statements: (1) financial
statements for the preceding year and (2) the sales forecast for the coming year. A
variety of assumptions must also be made. The company that we will use to illustrate the simplified approaches to pro forma preparation is Vectra Manufacturing, which manufactures and sells one product. It has two basic product models—X and Y—which are produced by the same process but require different
amounts of raw material and labor.
Preceding Year’s Financial Statements
The income statement for the firm’s 2003 operations is given in Table 3.12. It
indicates that Vectra had sales of $100,000, total cost of goods sold of $80,000,
net profits before taxes of $9,000, and net profits after taxes of $7,650. The firm
paid $4,000 in cash dividends, leaving $3,650 to be transferred to retained earnings. The firm’s balance sheet for 2003 is given in Table 3.13.
TABLE 3.12
Vectra Manufacturing’s Income
Statement for the Year Ended
December 31, 2003
Sales revenue
Model X (1,000 units at $20/unit)
$20,000
Model Y (2,000 units at $40/unit)
8
0
,0
0
0
Total sales
$100,000
Less: Cost of goods sold
Labor
Material A
Material B
Overhead
Total cost of goods sold
Gross profits
Less: Operating expenses
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (0.15 $9,000)
Net profits after taxes
Less: Common stock dividends
To retained earnings
$28,500
8,000
5,500
3
8
,0
0
0
80,000
$ 20,000
1
0
,0
0
0
$ 10,000
1
,0
0
0
$ 9,000
1,350
$ 7,650
4
,0
0
0
$
3
,
6
5
0
120
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Introduction to Managerial Finance
TABLE 3.13
Vectra Manufacturing’s Balance Sheet,
December 31, 2003
Assets
Liabilities and Stockholders’ Equity
Cash
$ 6,000
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
Accounts payable
$ 7,000
4,000
Taxes payable
300
13,000
Notes payable
8,300
1
6
,0
0
0
$39,000
Other current liabilities
$
5
1
,0
0
0
$90,000
Long-term debt
Total current liabilities
3
,4
0
0
$19,000
$18,000
Stockholders’ equity
Common stock
$30,000
Retained earnings
3,000
$2
Total liabilities and
stockholders’ equity
$90,000
Sales Forecast
Just as for the cash budget, the key input for pro forma statements is the sales
forecast. Vectra Manufacturing’s sales forecast for the coming year, based on
both external and internal data, is presented in Table 3.14. The unit sale prices
of the products reflect an increase from $20 to $25 for model X and from $40
to $50 for model Y. These increases are necessary to cover anticipated increases
in costs.
Review Question
3–13
What is the purpose of pro forma statements? What inputs are required
for preparing them using the simplified approaches?
TABLE 3.14
2004 Sales
Forecast
for Vectra
Manufacturing
Unit sales
Model X
1,500
Model Y
1,950
Dollar sales
Model X ($25/unit)
$ 37,500
Model Y ($50/unit)
97,500
$
1
35
,00
0
Total
CHAPTER 3
LG5
Cash Flow and Financial Planning
121
3.5 Preparing the Pro Forma Income Statement
percent-of-sales method
A simple method for developing
the pro forma income statement;
it forecasts sales and then
expresses the various income
statement items as percentages
of projected sales.
A simple method for developing a pro forma income statement is the percent-ofsales method. It forecasts sales and then expresses the various income statement
items as percentages of projected sales. The percentages used are likely to be the
percentages of sales for those items in the previous year. By using dollar values
taken from Vectra’s 2003 income statement (Table 3.12), we find that these percentages are
Cost of goods sold
$80,000
80.0%
Sales
$100,000
Operating expenses
$10,000
10.0%
Sales
$100,000
Interest expense
$1,000
1.0%
Sales
$100,000
Applying these percentages to the firm’s forecast sales of $135,000 (developed in
Table 3.14), we get the 2004 pro forma income statement shown in Table 3.15.
We have assumed that Vectra will pay $4,000 in common stock dividends, so the
expected contribution to retained earnings is $6,327. This represents a considerable increase over $3,650 in the preceding year (see Table 3.12).
Considering Types of Costs and Expenses
The technique that is used to prepare the pro forma income statement in Table
3.15 assumes that all the firm’s costs and expenses are variable. That is, we
assumed that for a given percentage increase in sales, the same percentage increase
TABLE 3.15
A Pro Forma Income
Statement, Using
the Percent-of-Sales
Method, for Vectra
Manufacturing
for the Year Ended
December 31, 2004
Sales revenue
$135,000
Less: Cost of goods sold (0.80)
1
0
8
,0
0
0
$ 27,000
Gross profits
Less: Operating expenses (0.10)
Operating profits
Less: Interest expense (0.01)
Net profits before taxes
Less: Taxes (0.15 $12,150)
Net profits after taxes
Less: Common stock dividends
To retained earnings
13,500
$ 13,500
1
,3
5
0
$ 12,150
1
,8
2
3
$ 10,327
4,000
$
6
,3
2
7
122
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Introduction to Managerial Finance
in cost of goods sold, operating expenses, and interest expense would result. For
example, as Vectra’s sales increased by 35 percent (from $100,000 in 2003 to
$135,000 projected for 2004), we assumed that its costs of goods sold also
increased by 35 percent (from $80,000 in 2003 to $108,000 in 2004). On the
basis of this assumption, the firm’s net profits before taxes also increased by 35
percent (from $9,000 in 2003 to $12,150 projected for 2004).
This approach implies that the firm will not receive the benefits that result
from fixed costs when sales are increasing.9 Clearly, though, if the firm has fixed
costs, these costs do not change when sales increase; the result is increased profits. But by remaining unchanged when sales decline, these costs tend to lower
profits. Therefore, the use of past cost and expense ratios generally tends to
understate profits when sales are increasing. (Likewise, it tends to overstate profits when sales are decreasing.) The best way to adjust for the presence of fixed
costs when preparing a pro forma income statement is to break the firm’s historical costs and expenses into fixed and variable components.10
EXAMPLE
Vectra Manufacturing’s 2003 actual and 2004 pro forma income statements,
broken into fixed and variable cost and expense components, follow:
Vectra Manufacturing
Income Statements
Sales revenue
2003
Actual
2004
Pro forma
$100,000
$135,000
40,000
40,000
40,000
$ 20,000
54,000
$ 41,000
Less: Cost of good sold
Fixed cost
Variable cost (0.40 sales)
Gross profits
Less: Operating expenses
Fixed expense
Variable expense (0.05 sales)
Operating profits
Less: Interest expense (all fixed)
Net profits before taxes
Less: Taxes (0.15 net profits before taxes)
Net profits after taxes
5,000
5,000
5,000
$ 10,000
6,750
$ 29,250
1,000
$ 9,000
1,000
$ 28,250
1,350
$ 7,650
4,238
$ 24,012
9. The potential returns as well as risks resulting from use of fixed (operating and financial) costs to create “leverage” are discussed in Chapter 12. The key point to recognize here is that when the firm’s revenue is increasing, fixed
costs can magnify returns.
10. The application of regression analysis—a statistically based technique for measuring the relationship between
variables—to past cost data as they relate to past sales could be used to develop equations that recognize the fixed
and variable nature of each cost. Such equations could be employed when preparing the pro forma income statement
from the sales forecast. The use of the regression approach in pro forma income statement preparation is widespread, and many computer software packages for use in pro forma preparation rely on this technique. Expanded
discussions of the application of this technique can be found in most second-level managerial finance texts.
CHAPTER 3
FOCUS ON ETHICS
Cash Flow and Financial Planning
123
In Practice
Critical Ethical Lapse at Critical Path
Critical Path provides a fascinating study in how managers can
seem to be maximizing shareholder wealth by making financial
projections that primarily benefit
the managers themselves. This Silicon Valley dot-com publicized
wildly optimistic sales projections
for its leading-edge corporate
e-mail services at a time when its
CEO was privately trying to sell the
company at a price well above the
current stock price. As the fiscal
year-end neared and no buyer took
the bait, sales personnel and
accountants were pressured into
doing whatever was necessary to
try to approach the projected numbers. Business Week quoted a former sales manager: “The line
between right and wrong wasn’t
just blurred—it was wiped out.”
Could Critical Path stockholders have benefited if an acquisition
had been completed before the
actual results were reported? Pos-
sibly—although ensuing lawsuits
and an SEC investigation into
accounting irregularities leave that
open to doubt. But there is no
doubt that the new acquirer’s
stockholders would have been
shortchanged. So much for maximizing shareholder wealth within
ethical constraints!
This isn’t just a case of wishful thinking. Managers who anticipated personal profits after taking
a public company private through
a “leveraged buyout” have occasionally underestimated sales and
profits so that they would pay a
lower price to existing shareholders. The phenomenal trust that
stockholders put in financial managers can be easily abused
through either misuse of funds or
manipulation of the better information that managers possess.
Don’t laws and the SEC offer
enough protection against publicizing unrealistic financial fore-
casts? The Private Securities Litigation Reform Act of 1995 requires
that companies disclose risks and
uncertainties that may cause public “forward-looking statements”
not to materialize. Accordingly,
Fifth Third Bankcorp was careful
to note six reasons why the anticipated benefits from its acquisition
of Old Kent Financial might not
come to pass, including changes in
bank competition, interest rates,
and the general economy. Furthermore, to keep companies from
selectively disclosing key developments to Wall Street securities
analysts but not to the general
public, the SEC adopted Regulation
FD (for Fair Disclosure) in 2000.
Unfortunately, though, companies
do not have to release revisions of
forecasts, and this loophole leaves
room for the ethical lapses seen at
Critical Path.
Breaking Vectra’s costs and expenses into fixed and variable components
provides a more accurate projection of its pro forma profit. By assuming that all
costs are variable (as shown in Table 3.15), we find that projected net profits
before taxes would continue to equal 9 percent of sales (in 2003, $9,000 net profits before taxes $100,000 sales). Therefore, the 2004 net profits before taxes
would have been $12,150 (0.09 $135,000 projected sales) instead of the
$28,250 obtained by using the firm’s fixed-cost–variable-cost breakdown.
Clearly, when using a simplified approach to prepare a pro forma income
statement, we should break down costs and expenses into fixed and variable
components.
Review Questions
3–14
3–15
How is the percent-of-sales method used to prepare pro forma income
statements?
Why does the presence of fixed costs cause the percent-of-sales method of
pro forma income statement preparation to fail? What is a better
method?
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LG5
3.6 Preparing the Pro Forma Balance Sheet
judgmental approach
A simplified approach for preparing the pro forma balance sheet
under which the values of certain
balance sheet accounts are
estimated and the firm’s external
financing is used as a balancing,
or “plug,” figure.
external financing required
(“plug” figure)
Under the judgmental approach
for developing a pro forma
balance sheet, the amount of
external financing needed to
bring the statement into balance.
A number of simplified approaches are available for preparing the pro forma balance sheet. Probably the best and most popular is the judgmental approach,11
under which the values of certain balance sheet accounts are estimated and the
firm’s external financing is used as a balancing, or “plug,” figure. To apply the
judgmental approach to prepare Vectra Manufacturing’s 2004 pro forma balance
sheet, a number of assumptions must be made about levels of various balance sheet
accounts:
1. A minimum cash balance of $6,000 is desired.
2. Marketable securities are assumed to remain unchanged from their current
level of $4,000.
3. Accounts receivable on average represent 45 days of sales. Because Vectra’s
annual sales are projected to be $135,000, accounts receivable should average $16,875 (1/8 $135,000). (Forty-five days expressed fractionally is oneeighth of a year: 45/360 1/8.)
4. The ending inventory should remain at a level of about $16,000, of which 25
percent (approximately $4,000) should be raw materials and the remaining
75 percent (approximately $12,000) should consist of finished goods.
5. A new machine costing $20,000 will be purchased. Total depreciation for the
year is $8,000. Adding the $20,000 acquisition to the existing net fixed assets
of $51,000 and subtracting the depreciation of $8,000 yield net fixed assets
of $63,000.
6. Purchases are expected to represent approximately 30% of annual sales,
which in this case is approximately $40,500 (0.30 $135,000). The firm
estimates that it can take 72 days on average to satisfy its accounts payable.
Thus accounts payable should equal one-fifth (72 days 360 days) of the
firm’s purchases, or $8,100 (1/5 $40,500).
7. Taxes payable are expected to equal one-fourth of the current year’s tax liability, which equals $455 (one-fourth of the tax liability of $1,823 shown in
the pro forma income statement in Table 3.15).
8. Notes payable are assumed to remain unchanged from their current level of
$8,300.
9. No change in other current liabilities is expected. They remain at the level of
the previous year: $3,400.
10. The firm’s long-term debt and its common stock are expected to remain
unchanged at $18,000 and $30,000, respectively; no issues, retirements, or
repurchases of bonds or stocks are planned.
11. Retained earnings will increase from the beginning level of $23,000 (from the
balance sheet dated December 31, 2003, in Table 3.13) to $29,327. The
increase of $6,327 represents the amount of retained earnings calculated in
the year-end 2004 pro forma income statement in Table 3.15.
A 2004 pro forma balance sheet for Vectra Manufacturing based on these
assumptions is presented in Table 3.16. A “plug” figure—called the external fi11. The judgmental approach represents an improved version of the often discussed percent-of-sales approach to pro
forma balance sheet preparation. Because the judgmental approach requires only slightly more information and
should yield better estimates than the somewhat naive percent-of-sales approach, it is presented here.
CHAPTER 3
TABLE 3.16
125
Cash Flow and Financial Planning
A Pro Forma Balance Sheet, Using the Judgmental Approach,
for Vectra Manufacturing (December 31, 2004)
Assets
Liabilities and Stockholders’ Equity
Cash
$ 6,000
Marketable securities
Accounts receivable
4,000
Taxes payable
455
Notes payable
8,300
Other current liabilities
Raw materials
$ 4,000
Finished goods
1
2
,0
0
0
Total current assets
Net fixed assets
Total assets
$ 8,100
16,875
Inventories
Total inventory
Accounts payable
Total current liabilities
Long-term debt
3,400
$ 20,255
$ 18,000
16,000
$ 42,875
Stockholders’ equity
Common stock
$ 30,000
$
6
3
,0
0
0
$
1
0
5
,
8
7
5
Retained earnings
$ 2
9
,3
2
7
$ 97,582
Total
External financing requireda
Total liabilities and
stockholders’ equity
$
8
,2
9
3
$105,875
aThe amount of external financing needed to force the firm’s balance sheet to balance. Because of the nature of the judgmental approach, the balance sheet is not expected to balance without some type of adjustment.
nancing required—of $8,293 is needed to bring the statement into balance. This
means that the firm will have to obtain about $8,293 of additional external
financing to support the increased sales level of $135,000 for 2004.
A positive value for “external financing required,” like that shown in Table
3.16, means that to support the forecast level of operation, the firm must raise
funds externally using debt and/or equity financing or by reducing dividends.
Once the form of financing is determined, the pro forma balance sheet is modified
to replace “external financing required” with the planned increases in the debt
and/or equity accounts.
A negative value for “external financing required” indicates that the firm’s
forecast financing is in excess of its needs. In this case, funds are available for use
in repaying debt, repurchasing stock, or increasing dividends. Once the specific
actions are determined, “external financing required” is replaced in the pro
forma balance sheet with the planned reductions in the debt and/or equity
accounts. Obviously, besides being used to prepare the pro forma balance sheet,
the judgmental approach is also frequently used specifically to estimate the firm’s
financing requirements.
Review Questions
3–16
3–17
Describe the judgmental approach for simplified preparation of the pro
forma balance sheet.
What is the significance of the “plug” figure, external financing required?
Differentiate between strategies associated with positive and with negative values for external financing required.
126
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LG6
3.7 Evaluation of Pro Forma Statements
It is difficult to forecast the many variables involved in preparing pro forma statements. As a result, investors, lenders, and managers frequently use the techniques
presented in this chapter to make rough estimates of pro forma financial statements. However, it is important to recognize the basic weaknesses of these simplified approaches. The weaknesses lie in two assumptions: (1) that the firm’s
past financial condition is an accurate indicator of its future, and (2) that certain
variables (such as cash, accounts receivable, and inventories) can be forced to
take on certain “desired” values. These assumptions cannot be justified solely on
the basis of their ability to simplify the calculations involved. However, despite
their weaknesses, the simplified approaches to pro forma statement preparation
are likely to remain popular because of their relative simplicity. Eventually, the
use of computers to streamline financial planning will become the norm.
However pro forma statements are prepared, analysts must understand how
to use them to make financial decisions. Both financial managers and lenders can
use pro forma statements to analyze the firm’s inflows and outflows of cash, as
well as its liquidity, activity, debt, profitability, and market value. Various ratios
can be calculated from the pro forma income statement and balance sheet to evaluate performance. Cash inflows and outflows can be evaluated by preparing a
pro forma statement of cash flows. After analyzing the pro forma statements, the
financial manager can take steps to adjust planned operations to achieve shortterm financial goals. For example, if projected profits on the pro forma income
statement are too low, a variety of pricing and/or cost-cutting actions might be
initiated. If the projected level of accounts receivable on the pro forma balance
sheet is too high, changes in credit or collection policy may be called for. Pro
forma statements are therefore of great importance in solidifying the firm’s financial plans for the coming year.
Review Questions
3–18
3–19
What are the two key weaknesses of the simplified approaches to preparing pro forma statements?
What is the financial manager’s objective in evaluating pro forma
statements?
S U M M A RY
FOCUS ON VALUE
Cash flow, the lifeblood of the firm, is a key determinant of the value of the firm. The financial manager must plan and manage—create, allocate, conserve, and monitor—the firm’s
cash flow. The goal is to ensure the firm’s solvency by meeting financial obligations in a
CHAPTER 3
Cash Flow and Financial Planning
127
timely manner and to generate positive cash flow for the firm’s owners. Both the magnitude
and the risk of the cash flows generated on behalf of the owners determine the firm’s value.
In order to carry out the responsibility to create value for owners, the financial manager
uses tools such as cash budgets and pro forma financial statements as part of the process of
generating positive cash flow. Good financial plans should result in large free cash flows
that fully satisfy creditor claims and produce positive cash flows on behalf of owners.
Clearly, the financial manager must use deliberate and careful planning and management of
the firm’s cash flows in order to achieve the firm’s goal of maximizing share price.
REVIEW OF LEARNING GOALS
Understand the effect of depreciation on the
firm’s cash flows, the depreciable value of an
asset, its depreciable life, and tax depreciation methods. Depreciation is an important factor affecting a
firm’s cash flow. The depreciable value of an asset
and its depreciable life are determined by using the
modified accelerated cost recovery system (MACRS)
standards in the federal tax code. MACRS groups
assets (excluding real estate) into six property
classes based on length of recovery period—3, 5, 7,
10, 15, and 20 years—and can be applied over the
appropriate period by using a schedule of yearly depreciation percentages for each period.
LG1
Discuss the firm’s statement of cash flows,
operating cash flow, and free cash flow. The
statement of cash flows is divided into operating,
investment, and financing flows. It reconciles
changes in the firm’s cash flows with changes in
cash and marketable securities for the period. Interpreting the statement of cash flows requires an understanding of basic financial principles and involves both the major categories of cash flow and
the individual items of cash inflow and outflow.
From a strict financial point of view, a firm’s operating cash flows, the cash flow it generates from
normal operations, is defined to exclude interest
and taxes; the simpler accounting view does not
make these exclusions. Of greater importance is a
firm’s free cash flow, which is the amount of cash
flow available to investors—the providers of debt
(creditors) and equity (owners).
LG2
Understand the financial planning process, including long-term (strategic) financial plans
and short-term (operating) financial plans. The two
LG3
key aspects of the financial planning process are
cash planning and profit planning. Cash planning
involves the cash budget or cash forecast. Profit
planning relies on the pro forma income statement
and balance sheet. Long-term (strategic) financial
plans act as a guide for preparing short-term (operating) financial plans. Long-term plans tend to
cover periods ranging from 2 to 10 years and are
updated periodically. Short-term plans most often
cover a 1- to 2-year period.
Discuss the cash-planning process and the
preparation, evaluation, and use of the cash
budget. The cash planning process uses the cash
budget, based on a sales forecast, to estimate shortterm cash surpluses and shortages. The cash budget
is typically prepared for a 1-year period divided into
months. It nets cash receipts and disbursements for
each period to calculate net cash flow. Ending cash
is estimated by adding beginning cash to the net
cash flow. By subtracting the desired minimum cash
balance from the ending cash, the financial manager
can determine required total financing (typically
borrowing with notes payable) or the excess cash
balance (typically investing in marketable securities). To cope with uncertainty in the cash budget,
sensitivity analysis or simulation can be used. A
firm must also consider its pattern of daily cash receipts and cash disbursements.
LG4
Explain the simplified procedures used to prepare and evaluate the pro forma income statement and the pro forma balance sheet. A pro forma
income statement can be developed by calculating
past percentage relationships between certain cost
and expense items and the firm’s sales and then apLG5
128
PART 1
Introduction to Managerial Finance
plying these percentages to forecasts. Because this
approach implies that all costs and expenses are
variable, it tends to understate profits when sales
are increasing and to overstate profits when sales
are decreasing. This problem can be avoided by
breaking down costs and expenses into fixed and
variable components. In this case, the fixed components remain unchanged from the most recent year,
and the variable costs and expenses are forecast on
a percent-of-sales basis.
Under the judgmental approach, the values of
certain balance sheet accounts are estimated and
others are calculated, frequently on the basis of their
relationship to sales. The firm’s external financing is
used as a balancing, or “plug,” figure. A positive
value for “external financing required” means that
the firm must raise funds externally or reduce divi-
SELF-TEST PROBLEMS
LG1
LG2
ST 3–1
dends; a negative value indicates that funds are
available for use in repaying debt, repurchasing
stock, or increasing dividends.
Cite the weaknesses of the simplified approaches to pro forma financial statement
preparation and the common uses of pro forma
statements. Simplified approaches for preparing pro
forma statements, although popular, can be criticized for assuming that the firm’s past financial condition is an accurate indicator of the future and that
certain variables can be forced to take on certain
“desired” values. Pro forma statements are commonly used to forecast and analyze the firm’s level
of profitability and overall financial performance so
that adjustments can be made to planned operations
in order to achieve short-term financial goals.
LG6
(Solutions in Appendix B)
Depreciation and cash flow A firm expects to have earnings before interest and
taxes (EBIT) of $160,000 in each of the next 6 years. It pays annual interest of
$1,500. The firm is considering the purchase of an asset that costs $140,000, requires $10,000 in installation cost, and has a recovery period of 5 years. It will
be the firm’s only asset, and the asset’s depreciation is already reflected in its
EBIT estimates.
a. Calculate the annual depreciation for the asset purchase using the MACRS
depreciation percentages in Table 3.2 on page 100.
b Calculate the annual operating cash flows for each of the 6 years, using both
the accounting and the finance definitions of operating cash flow. Assume
that the firm is subject to a 40% ordinary tax rate.
c. Say the firm’s net fixed assets, current assets, accounts payable, and accruals
had the following values at the start and end of the final year (year 6). Calculate the firm’s free cash flow (FCF) for that year.
Account
Net fixed assets
Year 6
Start
$ 7,500
Year 6
End
$
0
Current assets
90,000
110,000
Accounts payable
40,000
45,000
8,000
7,000
Accruals
d. Compare and discuss the significance of each value calculated in parts b and c.
LG4
LG5
ST 3–2
Cash budget and pro forma balance sheet inputs Jane McDonald, a financial
analyst for Carroll Company, has prepared the following sales and cash disbursement estimates for the period February–June of the current year.
CHAPTER 3
Cash Flow and Financial Planning
Month
Sales
Cash
disbursements
February
$500
$400
March
600
300
April
400
600
May
200
500
June
200
200
129
Ms. McDonald notes that historically, 30% of sales have been for cash. Of
credit sales, 70% are collected 1 month after the sale, and the remaining 30%
are collected 2 months after the sale. The firm wishes to maintain a minimum
ending balance in its cash account of $25. Balances above this amount would be
invested in short-term government securities (marketable securities), whereas
any deficits would be financed through short-term bank borrowing (notes
payable). The beginning cash balance at April 1 is $115.
a. Prepare a cash budget for April, May, and June.
b. How much financing, if any, at a maximum would Carroll Company require
to meet its obligations during this 3-month period?
c. A pro forma balance sheet dated at the end of June is to be prepared from the
information presented. Give the size of each of the following: cash, notes
payable, marketable securities, and accounts receivable.
LG5
ST 3–3
Pro forma income statement Euro Designs, Inc., expects sales during 2004 to
rise from the 2003 level of $3.5 million to $3.9 million. Because of a scheduled
large loan payment, the interest expense in 2004 is expected to drop to
$325,000. The firm plans to increase its cash dividend payments during 2004 to
$320,000. The company’s year-end 2003 income statement follows.
Euro Designs, Inc.
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$3,500,000
Less: Cost of goods sold
1,925,000
$1,575,000
Gross profits
Less: Operating expenses
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate 40%)
Net profits after taxes
Less: Cash dividends
To retained earnings
420,000
$1,155,000
400,000
$ 755,000
302,000
$ 453,000
250,000
$ 203,000
a. Use the percent-of-sales method to prepare a 2004 pro forma income statement for Euro Designs, Inc.
b. Explain why the statement may underestimate the company’s actual 2004
pro forma income.
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PROBLEMS
LG1
3–1
Depreciation On March 20, 2003, Norton Systems acquired two new assets.
Asset A was research equipment costing $17,000 and having a 3-year recovery
period. Asset B was duplicating equipment having an installed cost of
$45,000 and a 5-year recovery period. Using the MACRS depreciation percentages in Table 3.2 on page 100, prepare a depreciation schedule for each of
these assets.
LG2
3–2
Accounting cash flow A firm had earnings after taxes of $50,000 in 2003.
Depreciation charges were $28,000, and a $2,000 charge for amortization of a
bond discount was incurred. What was the firm’s accounting cash flow from
operations (see Equation 3.1) during 2003?
LG1
LG2
3–3
MACRS depreciation expense and accounting cash flow Pavlovich Instruments, Inc., a maker of precision telescopes, expects to report pre-tax income of
$430,000 this year. The company’s financial manager is considering the timing
of a purchase of new computerized lens grinders. The grinders will have an
installed cost of $80,000 and a cost recovery period of 5 years. They will be
depreciated using the MACRS schedule.
a. If the firm purchases the grinders before year end, what depreciation expense
will it be able to claim this year? (Use Table 3.2 on page 100.)
b. If the firm reduces its reported income by the amount of the depreciation
expense calculated in part a, what tax savings will result?
c. Assuming that Pavlovich does purchase the grinders this year and that
they are its only depreciable asset, use the accounting definition given
in Equation 3.1 to find the firm’s cash flow from operations for the
year.
LG1
LG2
3–4
Depreciation and accounting cash flow A firm in the third year of depreciating its only asset, which originally cost $180,000 and has a 5-year MACRS
recovery period, has gathered the following data relative to the current year’s
operations.
Accruals
Current assets
Interest expense
Sales revenue
Inventory
Total costs before depreciation, interest, and taxes
Tax rate on ordinary income
$ 15,000
120,000
15,000
400,000
70,000
290,000
40%
a. Use the relevant data to determine the accounting cash flow from operations
(see Equation 3.1) for the current year.
b. Explain the impact that depreciation, as well as any other noncash charges,
has on a firm’s cash flows.
LG2
3–5
Classifying inflows and outflows of cash Classify each of the following items as
an inflow (I) or an outflow (O) of cash, or as neither (N).
CHAPTER 3
Item
Change ($)
Cash
Accounts payable
Notes payable
Long-term debt
Inventory
Fixed assets
LG2
3–6
Cash Flow and Financial Planning
100
1,000
500
2,000
200
400
Item
Change ($)
Accounts receivable
Net profits
Depreciation
Repurchase of stock
Cash dividends
Sale of stock
700
600
100
600
800
1,000
131
Finding operating and free cash flows Consider the balance sheets and selected
data from the income statement of Keith Corporation that follow.
a. Calculate the firm’s accounting cash flow from operations for the year ended
December 31, 2003, using Equation 3.1.
b. Calculate the firm’s operating cash flow (OCF) for the year ended
December 31, 2003, using Equation 3.2.
c. Calculate the firm’s free cash flow (FCF) for the year ended December 31,
2003, using Equation 3.3.
d. Interpret, compare, and contrast your cash flow estimates in parts a, b, and c.
Keith Corporation
Balance Sheets
December 31
Assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets
Less: Accumulated depreciation
Net fixed assets
Total assets
2003
2002
$ 1,500
1,800
2,000
2,900
$ 8,200
$29,500
14,700
$14,800
$23,000
$ 1,000
1,200
1,800
2,800
$ 6,800
$28,100
13,100
$15,000
$21,800
$ 1,600
2,800
200
$ 4,600
$ 5,000
$10,000
3,400
$13,400
$23,000
$ 1,500
2,200
300
$ 4,000
$ 5,000
$10,000
2,800
$12,800
$21,800
Liabilities and Stockholders’ Equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
Income Statement Data (2003)
Depreciation expense
Earnings before interest and taxes (EBIT)
Taxes
Net profits after taxes
$11,600
2,700
933
1,400
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Introduction to Managerial Finance
LG4
3–7
Cash receipts A firm has actual sales of $65,000 in April and $60,000 in May.
It expects sales of $70,000 in June and $100,000 in July and in August. Assuming that sales are the only source of cash inflows and that half of them are for
cash and the remainder are collected evenly over the following 2 months, what
are the firm’s expected cash receipts for June, July, and August?
LG4
3–8
Cash disbursements schedule Maris Brothers, Inc., needs a cash disbursement
schedule for the months of April, May, and June. Use the format of Table 3.9
and the following information in its preparation.
Sales: February $500,000; March $500,000; April $560,000; May $610,000; June $650,000; July $650,000
Purchases: Purchases are calculated as 60% of the next month’s sales, 10%
of purchases are made in cash, 50% of purchases are paid for 1 month after
purchase, and the remaining 40% of purchases are paid for 2 months after
purchase.
Rent: The firm pays rent of $8,000 per month.
Wages and salaries: Base wage and salary costs are fixed at $6,000 per
month plus a variable cost of 7% of the current month’s sales.
Taxes: A tax payment of $54,500 is due in June.
Fixed asset outlays: New equipment costing $75,000 will be bought and paid
for in April.
Interest payments: An interest payment of $30,000 is due in June.
Cash dividends: Dividends of $12,500 will be paid in April.
Principal repayments and retirements: No principal repayments or retirements are due during these months.
LG4
LG4
3–9
Cash budget—Basic Grenoble Enterprises had sales of $50,000 in March and
$60,000 in April. Forecast sales for May, June, and July are $70,000, $80,000,
and $100,000, respectively. The firm has a cash balance of $5,000 on May 1 and
wishes to maintain a minimum cash balance of $5,000. Given the following
data, prepare and interpret a cash budget for the months of May, June, and July.
(1) The firm makes 20% of sales for cash, 60% are collected in the next month,
and the remaining 20% are collected in the second month following sale.
(2) The firm receives other income of $2,000 per month.
(3) The firm’s actual or expected purchases, all made for cash, are $50,000,
$70,000, and $80,000 for the months of May through July, respectively.
(4) Rent is $3,000 per month.
(5) Wages and salaries are 10% of the previous month’s sales.
(6) Cash dividends of $3,000 will be paid in June.
(7) Payment of principal and interest of $4,000 is due in June.
(8) A cash purchase of equipment costing $6,000 is scheduled in July.
(9) Taxes of $6,000 are due in June.
3–10
Cash budget—Advanced The actual sales and purchases for Xenocore, Inc., for
September and October 2003, along with its forecast sales and purchases for the
period November 2003 through April 2004, follow.
CHAPTER 3
Cash Flow and Financial Planning
Year
Month
Sales
Purchases
2003
2003
2003
2003
2004
2004
2004
2004
September
October
November
December
January
February
March
April
$210,000
250,000
170,000
160,000
140,000
180,000
200,000
250,000
$120,000
150,000
140,000
100,000
80,000
110,000
100,000
90,000
133
The firm makes 20% of all sales for cash and collects on 40% of its sales in
each of the 2 months following the sale. Other cash inflows are expected to be
$12,000 in September and April, $15,000 in January and March, and $27,000
in February. The firm pays cash for 10% of its purchases. It pays for 50% of its
purchases in the following month and for 40% of its purchases 2 months later.
Wages and salaries amount to 20% of the preceding month’s sales. Rent of
$20,000 per month must be paid. Interest payments of $10,000 are due in January and April. A principal payment of $30,000 is also due in April. The firm
expects to pay cash dividends of $20,000 in January and April. Taxes of
$80,000 are due in April. The firm also intends to make a $25,000 cash purchase of fixed assets in December.
a. Assuming that the firm has a cash balance of $22,000 at the beginning of
November, determine the end-of-month cash balances for each month,
November through April.
b. Assuming that the firm wishes to maintain a $15,000 minimum cash balance,
determine the required total financing or excess cash balance for each month,
November through April.
c. If the firm were requesting a line of credit to cover needed financing for the
period November to April, how large would this line have to be? Explain
your answer.
LG4
3–11
Cash flow concepts The following represent financial transactions that
Johnsfield & Co. will be undertaking in the next planning period. For each
transaction, check the statement or statements that will be affected immediately.
Statement
Transaction
Cash sale
Credit sale
Accounts receivable are collected
Asset with 5-year life is purchased
Depreciation is taken
Amortization of goodwill is taken
Sale of common stock
Retirement of outstanding bonds
Fire insurance premium is paid for the next 3 years
Cash budget
Pro forma income
statement
Pro forma balance
sheet
134
PART 1
LG4
Introduction to Managerial Finance
3–12
Cash budget—Sensitivity analysis Trotter Enterprises, Inc., has gathered the
following data in order to plan for its cash requirements and short-term investment opportunities for October, November, and December. All amounts are
shown in thousands of dollars.
October
Total cash
receipts
Total cash
disbursements
November
December
Pessimistic
Most
likely
Optimistic
Pessimistic
Most
likely
Optimistic
Pessimistic
Most
likely
Optimistic
$260
$342
$462
$200
$287
$366
$191
$294
$353
285
326
421
203
261
313
287
332
315
a. Prepare a sensitivity analysis of Trotter’s cash budget using $20,000 as the
beginning cash balance for October and a minimum required cash balance of
$18,000.
b. Use the analysis prepared in part a to predict Trotter’s financing needs and
investment opportunities over the months of October, November, and
December. Discuss how knowledge of the timing and amounts involved can
aid the planning process.
LG4
3–13
Multiple cash budgets—Sensitivity analysis Brownstein, Inc., expects sales of
$100,000 during each of the next 3 months. It will make monthly purchases of
$60,000 during this time. Wages and salaries are $10,000 per month plus 5% of
sales. Brownstein expects to make a tax payment of $20,000 in the next month
and a $15,000 purchase of fixed assets in the second month and to receive
$8,000 in cash from the sale of an asset in the third month. All sales and purchases are for cash. Beginning cash and the minimum cash balance are assumed
to be zero.
a. Construct a cash budget for the next 3 months.
b. Brownstein is unsure of the sales levels, but all other figures are certain. If
the most pessimistic sales figure is $80,000 per month and the most optimistic is $120,000 per month, what are the monthly minimum and maximum ending cash balances that the firm can expect for each of the 1-month
periods?
c. Briefly discuss how the financial manager can use the data in parts a and b to
plan for financing needs.
LG5
3–14
Pro forma income statement The marketing department of Metroline Manufacturing estimates that its sales in 2004 will be $1.5 million. Interest expense is
expected to remain unchanged at $35,000, and the firm plans to pay $70,000 in
cash dividends during 2004. Metroline Manufacturing’s income statement for
the year ended December 31, 2003, is given below, along with a breakdown of
the firm’s cost of goods sold and operating expenses into their fixed and variable
components.
CHAPTER 3
Cash Flow and Financial Planning
Metroline Manufacturing
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$1,400,000
Less: Cost of goods sold
910,000
$ 490,000
Gross profits
Less: Operating expenses
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate 40%)
Net profits after taxes
Less: Cash dividends
To retained earnings
120,000
$ 370,000
Metroline Manufacturing
Breakdown of
Costs and Expenses
into Fixed and Variable
Components for the
Year Ended December 31, 2003
Cost of goods sold
Fixed cost
$210,000
Variable cost
700,000
$910,000
35,000
$ 335,000
Total cost
134,000
$ 201,000
Operating expenses
Fixed expenses
Variable expenses
Total expenses
66,000
$ 135,000
135
$ 36,000
84,000
$120,000
a. Use the percent-of-sales method to prepare a pro forma income statement for
the year ended December 31, 2004.
b. Use fixed and variable cost data to develop a pro forma income statement for
the year ended December 31, 2004.
c. Compare and contrast the statements developed in parts a and b. Which statement probably provides the better estimate of 2004 income? Explain why.
LG5
3–15
Pro forma income statement—Sensitivity analysis Allen Products, Inc., wants
to do a sensitivity analysis for the coming year. The pessimistic prediction for
sales is $900,000; the most likely amount of sales is $1,125,000; and the optimistic prediction is $1,280,000. Allen’s income statement for the most recent
year follows.
Allen Products, Inc.
Income Statement for the
Year Ended December 31, 2003
Sales revenue
$937,500
Less: Cost of goods sold
421,875
$515,625
Gross profits
Less: Operating expenses
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate 25%)
Net profits after taxes
234,375
$281,250
30,000
$251,250
62,813
$188,437
a. Use the percent-of-sales method, the income statement for December 31,
2003, and the sales revenue estimates to develop pessimistic, most likely, and
optimistic pro forma income statements for the coming year.
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Introduction to Managerial Finance
b. Explain how the percent-of-sales method could result in an overstatement of
profits for the pessimistic case and an understatement of profits for the most
likely and optimistic cases.
c. Restate the pro forma income statements prepared in part a to incorporate
the following assumptions about costs:
$250,000 of the cost of goods sold is fixed; the rest is variable.
$180,000 of the operating expenses is fixed; the rest is variable.
All of the interest expense is fixed.
d. Compare your findings in part c to your findings in part a. Do your observations confirm your explanation in part b?
LG5
3–16
Pro forma balance sheet—Basic Leonard Industries wishes to prepare a pro
forma balance sheet for December 31, 2004. The firm expects 2004 sales to total
$3,000,000. The following information has been gathered.
(1) A minimum cash balance of $50,000 is desired.
(2) Marketable securities are expected to remain unchanged.
(3) Accounts receivable represent 10% of sales.
(4) Inventories represent 12% of sales.
(5) A new machine costing $90,000 will be acquired during 2004. Total depreciation for the year will be $32,000.
(6) Accounts payable represent 14% of sales.
(7) Accruals, other current liabilities, long-term debt, and common stock are
expected to remain unchanged.
(8) The firm’s net profit margin is 4%, and it expects to pay out $70,000 in cash
dividends during 2004.
(9) The December 31, 2003, balance sheet follows.
Leonard Industries
Balance Sheet
December 31, 2003
Assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
Liabilities and Stockholders’ Equity
$
45,000
Accounts payable
15,000
Accruals
255,000
340,000
$ 655,000
$ 600,000
$1,255,000
Other current liabilities
Total current liabilities
$ 395,000
60,000
30,000
$ 485,000
Long-term debt
$ 350,000
Common stock
$ 200,000
Retained earnings
$ 220,000
Total liabilities and
stockholders’ equity
$1,255,000
a. Use the judgmental approach to prepare a pro forma balance sheet dated
December 31, 2004, for Leonard Industries.
b. How much, if any, additional financing will Leonard Industries require in
2004? Discuss.
CHAPTER 3
137
Cash Flow and Financial Planning
c. Could Leonard Industries adjust its planned 2004 dividend to avoid the situation described in part b? Explain how.
LG5
3–17
Pro forma balance sheet Peabody & Peabody has 2003 sales of $10 million. It
wishes to analyze expected performance and financing needs for 2005—2 years
ahead. Given the following information, respond to parts a and b.
(1) The percents of sales for items that vary directly with sales are as
follows:
Accounts receivable, 12%
Inventory, 18%
Accounts payable, 14%
Net profit margin, 3%
(2) Marketable securities and other current liabilities are expected to remain
unchanged.
(3) A minimum cash balance of $480,000 is desired.
(4) A new machine costing $650,000 will be acquired in 2004, and equipment
costing $850,000 will be purchased in 2005. Total depreciation in 2004
is forecast as $290,000, and in 2005 $390,000 of depreciation will be
taken.
(5) Accruals are expected to rise to $500,000 by the end of 2005.
(6) No sale or retirement of long-term debt is expected.
(7) No sale or repurchase of common stock is expected.
(8) The dividend payout of 50% of net profits is expected to continue.
(9) Sales are expected to be $11 million in 2004 and $12 million in 2005.
(10) The December 31, 2003, balance sheet follows.
Peabody & Peabody
Balance Sheet
December 31, 2003
($000)
Assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
Liabilities and Stockholders’ Equity
$ 400
200
1,200
1,800
$3,600
$4,000
$7,600
Accounts payable
Accruals
Other current liabilities
Total current liabilities
$1,400
400
80
$1,880
Long-term debt
$2,000
Common equity
$3,720
Total liabilities and
stockholders’ equity
$7,600
a. Prepare a pro forma balance sheet dated December 31, 2005.
b. Discuss the financing changes suggested by the statement prepared in
part a.
LG5
3–18
Integrative—Pro forma statements Red Queen Restaurants wishes to prepare
financial plans. Use the financial statements and the other information provided
in what follows to prepare the financial plans.
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Introduction to Managerial Finance
Red Queen Restaurants
Income Statement for the
Year Ended December 31, 2003
Sales revenue
$800,000
Less: Cost of goods sold
600,000
$200,000
Gross profits
100,000
$100,000
Less: Operating expenses
Net profits before taxes
Less: Taxes (rate 40%)
40,000
$ 60,000
Net profits after taxes
20,000
$ 40,000
Less: Cash dividends
To retained earnings
Red Queen Restaurants
Balance Sheet
December 31, 2003
Assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
Liabilities and Stockholders’ Equity
$ 32,000
18,000
150,000
100,000
$300,000
$350,000
$650,000
Accounts payable
Taxes payable
Other current liabilities
Total current liabilities
$100,000
20,000
5,000
$125,000
Long-term debt
$200,000
Common stock
$150,000
Retained earnings
$175,000
Total liabilities and
stockholders’ equity
$650,000
The following financial data are also available:
(1) The firm has estimated that its sales for 2004 will be $900,000.
(2) The firm expects to pay $35,000 in cash dividends in 2004.
(3) The firm wishes to maintain a minimum cash balance of $30,000.
(4) Accounts receivable represent approximately 18% of annual sales.
(5) The firm’s ending inventory will change directly with changes in sales in
2004.
(6) A new machine costing $42,000 will be purchased in 2004. Total depreciation for 2004 will be $17,000.
(7) Accounts payable will change directly in response to changes in sales in
2004.
(8) Taxes payable will equal one-fourth of the tax liability on the pro forma
income statement.
(9) Marketable securities, other current liabilities, long-term debt, and common stock will remain unchanged.
a. Prepare a pro forma income statement for the year ended December 31,
2004, using the percent-of-sales method.
b. Prepare a pro forma balance sheet dated December 31, 2004, using the judgmental approach.
CHAPTER 3
139
Cash Flow and Financial Planning
c. Analyze these statements, and discuss the resulting external financing
required.
LG5
3–19
Integrative—Pro forma statements Provincial Imports, Inc., has assembled
statements and information to prepare financial plans for the coming year.
Provincial Imports, Inc.
Income Statement for the
Year Ended December 31, 2003
Sales revenue
$5,000,000
Less: Cost of goods sold
2,750,000
$2,250,000
Gross profits
Less: Operating expenses
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate 40%)
Net profits after taxes
Less: Cash dividends
To retained earnings
850,000
$1,400,000
200,000
$1,200,000
480,000
$ 720,000
288,000
$ 432,000
Provincial Imports, Inc.
Balance Sheet
December 31, 2003
Assets
Cash
Liabilities and Stockholders’ Equity
$ 200,000
Accounts payable
$ 700,000
Marketable securities
275,000
Taxes payable
95,000
Accounts receivable
625,000
Notes payable
200,000
Inventories
Total current assets
Net fixed assets
Total assets
500,000
$1,600,000
Other current liabilities
$
1
,4
0
0
,0
0
0
$3,000,000
Long-term debt
$ 500,000
Common stock
$
Retained earnings
,375,000
$1
$3,000,000
Total current liabilities
Total liabilities and equity
5,000
$1,000,000
75,000
Information related to financial projections for the year 2004:
(1) Projected sales are $6,000,000.
(2) Cost of goods sold includes $1,000,000 in fixed costs.
(3) Operating expense includes $250,000 in fixed costs.
(4) Interest expense will remain unchanged.
(5) The firm will pay cash dividends amounting to 40% of net profits after
taxes.
(6) Cash and inventories will double.
(7) Marketable securities, notes payable, long-term debt, and common stock
will remain unchanged.
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Introduction to Managerial Finance
(8) Accounts receivable, accounts payable, and other current liabilities will
change in direct response to the change in sales.
(9) A new computer system costing $356,000 will be purchased during the
year. Total depreciation expense for the year will be $110,000.
a. Prepare a pro forma income statement for the year ended December 31,
2004, using the information given and the percent-of-sales method.
b. Prepare a pro forma balance sheet as of December 31, 2004, using the information given and the judgmental approach. Include a reconciliation of the
retained earnings account.
c. Analyze these statements, and discuss the resulting external financing
required.
CHAPTER 3 CASE
Preparing Martin Manufacturing’s
2004 Pro Forma Financial Statements
T
o improve its competitive position, Martin Manufacturing is planning to
implement a major equipment modernization program. Included will be
replacement and modernization of key manufacturing equipment at a cost of
$400,000 in 2004. The planned program is expected to lower the variable cost
per unit of finished product. Terri Spiro, an experienced budget analyst, has
been charged with preparing a forecast of the firm’s 2004 financial position,
assuming replacement and modernization of manufacturing equipment. She
plans to use the 2003 financial statements presented on pages 92 and 93, along
with the key projected financial data summarized in the following table.
Martin Manufacturing Company
Key Projected Financial Data (2004)
Data item
Value
Sales revenue
Minimum cash balance
Inventory turnover (times)
Average collection period
Fixed-asset purchases
Dividend payments
Depreciation expense
Interest expense
Accounts payable increase
$6,500,000
$25,000
7.0
50 days
$400,000
$20,000
$185,000
$97,000
20%
Accruals and long-term debt
Unchanged
Notes payable, preferred and common stock
Unchanged
Required
a. Use the historical and projected financial data provided to prepare a pro
forma income statement for the year ended December 31, 2004. (Hint: Use
CHAPTER 3
Cash Flow and Financial Planning
141
the percent-of-sales method to estimate all values except depreciation expense
and interest expense, which have been estimated by management and
included in the table.)
b. Use the projected financial data along with relevant data from the pro forma
income statement prepared in part a to prepare the pro forma balance sheet
at December 31, 2004. (Hint: Use the judgmental approach.)
c. Will Martin Manufacturing Company need to obtain external financing to
fund the proposed equipment modernization program? Explain.
WEB EXERCISE
WW
W
Go to the Best Depreciation Calculator at the Fixed Asset Info. site, www.
fixedassetinfo.com/defaultCalc.asp. Use this calculator to determine the
straight-line, declining balance (using 200%), and MACRS depreciation schedules for the following items, using half-year averaging (the half-year convention).
Item
Date placed in service
Cost
Office furnishings
2/15/2002
$22,500
Laboratory equipment
5/27/2001
$14,375
9/5/2000
$45,863
Fleet vehicles
Make a chart comparing the depreciation amounts that these three methods
yield for the years 2002 to 2007. Discuss the implications of these differences.
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
I N T E G R AT I V E
C A S E
1
Track Software, Inc.
even years ago, after 15 years in public accounting, Stanley Booker,
CPA, resigned his position as Manager of Cost Systems for Davis,
Cohen, and O’Brien Public Accountants and started Track Software, Inc.
In the 2 years preceding his departure from Davis, Cohen, and O’Brien,
Stanley had spent nights and weekends developing a sophisticated costaccounting software program that became Track’s initial product offering. As the firm grew, Stanley planned to develop and expand the software product offerings—all of which would be related to streamlining
the accounting processes of medium- to large-sized manufacturers.
Although Track experienced losses during its first 2 years of operation—1997 and 1998—its profit has increased steadily from 1999 to the
present (2003). The firm’s profit history, including dividend payments
and contributions to retained earnings, is summarized in Table 1.
Stanley started the firm with a $100,000 investment—his savings of
$50,000 as equity and a $50,000 long-term loan from the bank. He had
hoped to maintain his initial 100 percent ownership in the corporation,
S
Table 1
Track Software, Inc.
Profit, Dividends, and Retained Earnings, 1997–2003
142
Dividends paid
(2)
Contribution to
retained earnings [(1) (2)]
(3)
Year
Net profits after taxes
(1)
1997
($50,000)
0
($50,000)
1998
( 20,000)
0
( 20,000)
1999
15,000
0
15,000
2000
35,000
0
35,000
2001
40,000
1,000
39,000
2002
43,000
3,000
40,000
2003
48,000
5,000
43,000
$
but after experiencing a $50,000 loss during the first year of operation
(1997), he sold 60 percent of the stock to a group of investors to obtain
needed funds. Since then, no other stock transactions have taken place.
Although he owns only 40 percent of the firm, Stanley actively manages
all aspects of its activities; the other stockholders are not active in management of the firm. The firm’s stock closed at $4.50 per share in 2002
and at $5.28 per share in 2003.
Stanley has just prepared the firm’s 2003 income statement, balance
sheet, and statement of retained earnings, shown in Tables 2, 3, and 4
(on pages 143–145), along with the 2002 balance sheet. In addition, he
has compiled the 2002 ratio values and industry average ratio values for
2003, which are applicable to both 2002 and 2003 and are summarized in
Table 5 (on page 145). He is quite pleased to have achieved record earnings of $48,000 in 2003, but he is concerned about the firm’s cash flows.
Specifically, he is finding it more and more difficult to pay the firm’s bills
in a timely manner and generate cash flows to investors—both creditors
and owners. To gain insight into these cash flow problems, Stanley is
planning to determine the firm’s 2003 operating cash flow (OCF) and free
cash flow (FCF).
Table 2
Track Software, Inc.
Income Statement ($000)
for the Year Ended December 31, 2003
Sales revenue
$1,550
Less: Cost of goods sold
1,030
$ 520
Gross profits
Less: Operating expenses
Selling expense
General and administrative expense
Depreciation expense
Total operating expense
Operating profits (EBIT)
Less: Interest expense
Net profits before taxes
Less: Taxes (20%)
Net profits after taxes
$150
270
11
431
$ 89
29
$ 60
12
$ 48
143
Table 3
Track Software, Inc.
Balance Sheets ($000)
December 31
Assets
2003
2002
$ 12
$ 31
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets
Less: Accumulated depreciation
Net fixed assets
Total assets
66
82
152
104
191
$421
$195
145
$362
$180
63
$132
$553
52
$128
$490
$136
$126
200
190
27
$363
25
$341
$ 38
$401
$ 40
$381
$ 20
$ 20
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Total liabilities
Stockholders’ equity
Common stock (50,000 shares outstanding
at $0.40 par value)
Paid-in capital in excess of par
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
144
30
30
102
$152
$553
59
$109
$490
Table 4
Track Software, Inc.
Statement of Retained Earnings ($000)
for the Year Ended December 31, 2003
Retained earnings balance (January 1, 2003)
$ 59
Plus: Net profits after taxes (for 2003)
48
Less: Cash dividends on common stock (paid during 2003)
( 5)
$102
Retained earnings balance (December 31, 2003)
Table 5
Ratio
Actual
2002
Industry average
2003
Current ratio
1.06
Quick ratio
0.63
1.10
10.40
12.45
29.6 days
20.2 days
Inventory turnover
Average collection period
Total asset turnover
2.66
1.82
3.92
Debt ratio
0.78
0.55
Times interest earned ratio
3.0
5.6
Gross profit margin
32.1%
42.3%
Operating profit margin
5.5%
12.4%
Net profit margin
3.0%
4.0%
Return on total assets (ROA)
8.0%
15.6%
Return on common equity (ROE)
36.4%
34.7%
Price/earnings (P/E) ratio
5.2
7.1
Market/book (M/B) ratio
2.1
2.2
145
Stanley is further frustrated by the firm’s inability to afford to hire a
software developer to complete development of a cost estimation package that is believed to have “blockbuster” sales potential. Stanley began
development of this package 2 years ago, but the firm’s growing complexity has forced him to devote more of his time to administrative
duties, thereby halting the development of this product. Stanley’s reluctance to fill this position stems from his concern that the added $80,000
per year in salary and benefits for the position would certainly lower the
firm’s earnings per share (EPS) over the next couple of years. Although
the project’s success is in no way guaranteed, Stanley believes that if the
money were spent to hire the software developer, the firm’s sales and
earnings would significantly rise once the 2- to 3-year development, production, and marketing process was completed.
With all of these concerns in mind, Stanley set out to review the various data to develop strategies that would help to ensure a bright future
for Track Software. Stanley believed that as part of this process, a thorough ratio analysis of the firm’s 2003 results would provide important
additional insights.
Required
a. (1) Upon what financial goal does Stanley seem to be focusing? Is it the correct goal? Why or why not?
(2) Could a potential agency problem exist in this firm? Explain.
b. Calculate the firm’s earnings per share (EPS) for each year, recognizing that
the number of shares of common stock outstanding has remained
unchanged since the firm’s inception. Comment on the EPS performance in
view of your response in part a.
c. Use the financial data presented to determine Track’s operating cash flow
(OCF) and free cash flow (FCF) in 2003. Evaluate your findings in light of
Track’s current cash flow difficulties.
d. Analyze the firm’s financial condition in 2003 as it relates to (1) liquidity,
(2) activity, (3) debt, (4) profitability, and (5) market, using the financial
statements provided in Tables 2 and 3 and the ratio data included in Table
5. Be sure to evaluate the firm on both a cross-sectional and a time-series
basis.
e. What recommendation would you make to Stanley regarding hiring a new
software developer? Relate your recommendation here to your responses in
part a.
146
PA R T
2
IMPORTANT
FINANCIAL
CONCEPTS
CHAPTERS IN THIS PART
4
Time Value of Money
5
Risk and Return
6
Interest Rates and Bond Valuation
7
Stock Valuation
Integrative Case 2: Encore International
147
CHAPTER
4
TIME VALUE
OF MONEY
L E A R N I N G
LG1
LG2
LG3
Discuss the role of time value in finance, the use
of computational tools, and the basic patterns of
cash flow.
Understand the concepts of future and present
value, their calculation for single amounts, and
the relationship of present value to future value.
Find the future value and the present value of both
an ordinary annuity and an annuity due, and find
the present value of a perpetuity.
LG4
LG5
LG6
G O A L S
Calculate both the future value and the present
value of a mixed stream of cash flows.
Understand the effect that compounding interest
more frequently than annually has on future value
and on the effective annual rate of interest.
Describe the procedures involved in (1) determining deposits to accumulate a future sum, (2) loan
amortization, (3) finding interest or growth rates,
and (4) finding an unknown number of periods.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand time-value-of-money
calculations in order to account for certain transactions
such as loan amortization, lease payments, and bond interest
rates.
Information systems: You need to understand time-value-ofmoney calculations in order to design systems that optimize the
firm’s cash flows.
Management: You need to understand time-value-of-money
calculations so that you can plan cash collections and dis-
148
bursements in a way that will enable the firm to get the greatest
value from its money.
Marketing: You need to understand time value of money
because funding for new programs and products must be justified financially using time-value-of-money techniques.
Operations: You need to understand time value of money
because investments in new equipment, in inventory, and in
production quantities will be affected by time-value-of-money
techniques.
LCV
IT ALL STARTS
WITH TIME (VALUE)
ow do managers decide which customers offer the highest profit potential? Should marketing programs focus on
new customer acquisitions? Or is it better
to increase repeat purchases by existing
customers or to implement programs
aimed at specific target markets? Time-value-of-money calculations can be a key part of such
decisions. A technique called lifetime customer valuation (LCV) calculates the value today (present value) of profits that new or existing customers are expected to generate in the future. After
comparing the cost to acquire or retain customers to the profit stream from those customers,
managers have the information they need to allocate marketing expenditures accordingly.
In most cases, existing customers warrant the greatest investment. Research shows that
increasing customer retention 5 percent raised the value of the average customer from 25 percent to 95 percent, depending on the industry.
Many dot-com retailers ignored this important finding as they rushed to get to the Web first.
As new companies, they had to spend to attract customers. But in the frenzy of the moment, they
didn’t monitor costs and compare those costs to sales. Their high customer acquisition costs often
exceeded what customers spent at the e-tailers’ Web sites—and the result was often bankruptcy.
Business-to-business (B2B) companies are now joining consumer product companies like
Lexus Motors and credit card issuer MBNA in using LCV. The technique has been updated to
include intangible factors, such as outsourcing potential and partnership quality. Even though
intangible factors complicate the methodology, the underlying principle is the same: Identify the
most profitable clients and allocate more resources to them. “It actually makes a lot of sense,”
says Bob Lento, senior vice president of sales at Convergys, a customer service and billing services provider. Which is more valuable and deserves more of the firm’s resources—a company
with whom Convergys does $20 million in business each year, with no expectation of growing that
business, or one with current business of $10 million that might develop into a $100-million client?
Convergys’s management instituted an LCV program several years ago to answer this question.
After engaging in a trial-and-error process to refine its formula, Convergys chose to include traditional LCV items such as repeat business and whether the customer bases purchasing decisions
solely on cost. Then it factors in such intangibles as the level within the customer company of a
salesperson’s contact (higher is better) and whether the customer perceives Convergys as a
strategic partner or a commodity service provider (strategic is better).
Thanks to LCV, Convergys’s Customer Management Group increased its operating income
by winning new business from old customers. The firm’s CFO, Steve Rolls, believes in LCV. “This
long-term view of customers gives us a much better picture of what we’re going after,” he says.
H
149
150
PART 2
Important Financial Concepts
LG1
4.1 The Role of Time Value in Finance
Hint The time value of
money is one of the most
important concepts in finance.
Money that the firm has in its
possession today is more
valuable than future payments
because the money it now has
can be invested and earn
positive returns.
Financial managers and investors are always confronted with opportunities to
earn positive rates of return on their funds, whether through investment in
attractive projects or in interest-bearing securities or deposits. Therefore, the timing of cash outflows and inflows has important economic consequences, which
financial managers explicitly recognize as the time value of money. Time value is
based on the belief that a dollar today is worth more than a dollar that will be
received at some future date. We begin our study of time value in finance by considering the two views of time value—future value and present value, the computational tools used to streamline time value calculations, and the basic patterns of
cash flow.
Future Value versus Present Value
time line
A horizontal line on which time
zero appears at the leftmost end
and future periods are marked
from left to right; can be used to
depict investment cash flows.
Financial values and decisions can be assessed by using either future value or present value techniques. Although these techniques will result in the same decisions,
they view the decision differently. Future value techniques typically measure cash
flows at the end of a project’s life. Present value techniques measure cash flows at
the start of a project’s life (time zero). Future value is cash you will receive at a
given future date, and present value is just like cash in hand today.
A time line can be used to depict the cash flows associated with a given
investment. It is a horizontal line on which time zero appears at the leftmost end
and future periods are marked from left to right. A line covering five periods (in
this case, years) is given in Figure 4.1. The cash flow occurring at time zero and
that at the end of each year are shown above the line; the negative values represent cash outflows ($10,000 at time zero) and the positive values represent cash
inflows ($3,000 inflow at the end of year 1, $5,000 inflow at the end of year 2,
and so on).
Because money has a time value, all of the cash flows associated with an
investment, such as those in Figure 4.1, must be measured at the same point in
time. Typically, that point is either the end or the beginning of the investment’s
life. The future value technique uses compounding to find the future value of each
cash flow at the end of the investment’s life and then sums these values to find the
investment’s future value. This approach is depicted above the time line in
Figure 4.2. The figure shows that the future value of each cash flow is measured
FIGURE 4.1
Time Line
Time line depicting an investment’s cash flows
–$10,000
$3,000
$5,000
0
1
2
$4,000
$3,000
$2,000
3
4
5
End of Year
CHAPTER 4
FIGURE 4.2
Compounding
and Discounting
Time line showing
compounding to find future
value and discounting to find
present value
Time Value of Money
151
Compounding
Future
Value
–$10,000
$3,000
$5,000
0
1
2
$4,000
$3,000
$2,000
3
4
5
End of Year
Present
Value
Discounting
at the end of the investment’s 5-year life. Alternatively, the present value technique uses discounting to find the present value of each cash flow at time zero
and then sums these values to find the investment’s value today. Application of
this approach is depicted below the time line in Figure 4.2.
The meaning and mechanics of compounding to find future value and of discounting to find present value are covered in this chapter. Although future value
and present value result in the same decisions, financial managers—because they
make decisions at time zero—tend to rely primarily on present value techniques.
Computational Tools
Time-consuming calculations are often involved in finding future and present values. Although you should understand the concepts and mathematics underlying
these calculations, the application of time value techniques can be streamlined.
We focus on the use of financial tables, hand-held financial calculators, and computers and spreadsheets as aids in computation.
Financial Tables
Financial tables include various future and present value interest factors that simplify time value calculations. The values shown in these tables are easily developed from formulas, with various degrees of rounding. The tables are typically
indexed by the interest rate (in columns) and the number of periods (in rows).
Figure 4.3 shows this general layout. The interest factor at a 20 percent interest
rate for 10 years would be found at the intersection of the 20% column and the
10-period row, as shown by the dark blue box. A full set of the four basic financial tables is included in Appendix A at the end of the book. These tables are
described more fully later in the chapter.
152
PART 2
Important Financial Concepts
FIGURE 4.3
Financial Tables
Layout and use
of a financial table
Interest Rate
Period
1%
2%
10%
20%
50%
1
2
3
X.XXX
10
20
50
Financial Calculators
Financial calculators also can be used for time value computations. Generally,
financial calculators include numerous preprogrammed financial routines. This
chapter and those that follow show the keystrokes for calculating interest factors
and making other financial computations. For convenience, we use the important financial keys, labeled in a fashion consistent with most major financial
calculators.
We focus primarily on the keys pictured and defined in Figure 4.4. We typically use four of the first five keys shown in the left column, along with the compute (CPT) key. One of the four keys represents the unknown value being calculated. (Occasionally, all five of the keys are used, with one representing the
unknown value.) The keystrokes on some of the more sophisticated calculators
are menu-driven: After you select the appropriate routine, the calculator prompts
you to input each value; on these calculators, a compute key is not needed to
obtain a solution. Regardless, any calculator with the basic future and present
value functions can be used in lieu of financial tables. The keystrokes for other
financial calculators are explained in the reference guides that accompany them.
Once you understand the basic underlying concepts, you probably will want
to use a calculator to streamline routine financial calculations. With a little prac-
FIGURE 4.4
Calculator Keys
Important financial keys
on the typical calculator
N
I
PV
PMT
FV
CPT
N — Number of periods
I — Interest rate per period
PV — Present value
PMT — Amount of payment (used only for annuities)
FV — Future value
CPT — Compute key used to initiate financial calculation
once all values are input
CHAPTER 4
Time Value of Money
153
tice, you can increase both the speed and the accuracy of your financial computations. Note that because of a calculator’s greater precision, slight differences are
likely to exist between values calculated by using financial tables and those found
with a financial calculator. Remember that conceptual understanding of the
material is the objective. An ability to solve problems with the aid of a calculator
does not necessarily reflect such an understanding, so don’t just settle for answers.
Work with the material until you are sure you also understand the concepts.
Computers and Spreadsheets
Hint Anyone familiar with
electronic spreadsheets, such as
Lotus or Excel, realizes that
most of the time-value-ofmoney calculations can be done
expeditiously by using the
special functions contained in
the spreadsheet.
Like financial calculators, computers and spreadsheets have built-in routines that
simplify time value calculations. We provide in the text a number of spreadsheet
solutions that identify the cell entries for calculating time values. The value for
each variable is entered in a cell in the spreadsheet, and the calculation is programmed using an equation that links the individual cells. If values of the variables are changed, the solution automatically changes as a result of the equation
linking the cells. In the spreadsheet solutions in this book, the equation that
determines the calculation is shown at the bottom of the spreadsheet.
It is important that you become familiar with the use of spreadsheets for several reasons.
• Spreadsheets go far beyond the computational abilities of calculators. They
offer a host of routines for important financial and statistical relationships.
They perform complex analyses, for example, that evaluate the probabilities
of success and the risks of failure for management decisions.
• Spreadsheets have the ability to program logical decisions. They make it possible to automate the choice of the best option from among two or more
alternatives. We give several examples of this ability to identify the optimal
selection among alternative investments and to decide what level of credit to
extend to customers.
• Spreadsheets display not only the calculated values of solutions but also the
input conditions on which solutions are based. The linkage between a
spreadsheet’s cells makes it possible to do sensitivity analysis—that is, to
evaluate the impacts of changes in conditions on the values of the solutions.
Managers, after all, are seldom interested simply in determining a single
value for a given set of conditions. Conditions change, and managers who are
not prepared to react quickly to take advantage of changes must suffer their
consequences.
• Spreadsheets encourage teamwork. They assemble details from different corporate divisions and consolidate them into a firm’s financial statements and
cash budgets. They integrate information from marketing, manufacturing,
and other functional organizations to evaluate capital investments. Laptop
computers provide the portability to transport these abilities and use spreadsheets wherever one might be—attending an important meeting at a firm’s
headquarters or visiting a distant customer or supplier.
• Spreadsheets enhance learning. Creating spreadsheets promotes one’s understanding of a subject. Because spreadsheets are interactive, one gets an
154
PART 2
Important Financial Concepts
immediate response to one’s entries. The interplay between computer and
user becomes a game that many find both enjoyable and instructive.
• Finally, spreadsheets communicate as well as calculate. Their output
includes tables and charts that can be incorporated into reports. They interplay with immense databases that corporations use for directing and controlling global operations. They are the nearest thing we have to a universal
business language.
The ability to use spreadsheets has become a prime skill for today’s managers.
As the saying goes, “Get aboard the bandwagon, or get run over.” The spreadsheet
solutions we present in this book will help you climb up onto that bandwagon!
Basic Patterns of Cash Flow
The cash flow—both inflows and outflows—of a firm can be described by its general pattern. It can be defined as a single amount, an annuity, or a mixed stream.
Single amount: A lump-sum amount either currently held or expected at
some future date. Examples include $1,000 today and $650 to be received at
the end of 10 years.
Annuity: A level periodic stream of cash flow. For our purposes, we’ll work
primarily with annual cash flows. Examples include either paying out or
receiving $800 at the end of each of the next 7 years.
Mixed stream: A stream of cash flow that is not an annuity; a stream of
unequal periodic cash flows that reflect no particular pattern. Examples
include the following two cash flow streams A and B.
Mixed cash flow stream
End of year
A
B
1
$ 100
$ 50
2
800
100
3
1,200
80
4
1,200
60
5
1,400
6
300
Note that neither cash flow stream has equal, periodic cash flows and that A
is a 6-year mixed stream and B is a 4-year mixed stream.
In the next three sections of this chapter, we develop the concepts and techniques for finding future and present values of single amounts, annuities, and
mixed streams, respectively. Detailed demonstrations of these cash flow patterns
are included.
CHAPTER 4
Time Value of Money
155
Review Questions
4–1
4–2
LG2
What is the difference between future value and present value? Which
approach is generally preferred by financial managers? Why?
Define and differentiate among the three basic patterns of cash flow: (1) a
single amount, (2) an annuity, and (3) a mixed stream.
4.2 Single Amounts
The most basic future value and present value concepts and computations concern single amounts, either present or future amounts. We begin by considering
the future value of present amounts. Then we will use the underlying concepts to
learn how to determine the present value of future amounts. You will see that
although future value is more intuitively appealing, present value is more useful
in financial decision making.
Future Value of a Single Amount
compound interest
Interest that is earned on a given
deposit and has become part of
the principal at the end of a
specified period.
principal
The amount of money on which
interest is paid.
future value
The value of a present amount at
a future date, found by applying
compound interest over a
specified period of time.
EXAMPLE
Imagine that at age 25 you began making annual purchases of $2,000 of an investment that earns a guaranteed 5 percent annually. At the end of 40 years, at age 65,
you would have invested a total of $80,000 (40 years $2,000 per year). Assuming that all funds remain invested, how much would you have accumulated at the
end of the fortieth year? $100,000? $150,000? $200,000? No, your $80,000
would have grown to $242,000! Why? Because the time value of money allowed
your investments to generate returns that built on each other over the 40 years.
The Concept of Future Value
We speak of compound interest to indicate that the amount of interest earned on
a given deposit has become part of the principal at the end of a specified period.
The term principal refers to the amount of money on which the interest is paid.
Annual compounding is the most common type.
The future value of a present amount is found by applying compound interest
over a specified period of time. Savings institutions advertise compound interest
returns at a rate of x percent, or x percent interest, compounded annually, semiannually, quarterly, monthly, weekly, daily, or even continuously. The concept of
future value with annual compounding can be illustrated by a simple example.
If Fred Moreno places $100 in a savings account paying 8% interest compounded annually, at the end of 1 year he will have $108 in the account—the initial principal of $100 plus 8% ($8) in interest. The future value at the end of the
first year is calculated by using Equation 4.1:
Future value at end of year 1 $100 (1 0.08) $108
(4.1)
If Fred were to leave this money in the account for another year, he would be
paid interest at the rate of 8% on the new principal of $108. At the end of this
156
PART 2
Important Financial Concepts
second year there would be $116.64 in the account. This amount would represent
the principal at the beginning of year 2 ($108) plus 8% of the $108 ($8.64) in
interest. The future value at the end of the second year is calculated by using
Equation 4.2:
Future value at end of year 2 $108 (1 0.08)
$116.64
(4.2)
Substituting the expression between the equals signs in Equation 4.1 for the
$108 figure in Equation 4.2 gives us Equation 4.3:
Future value at end of year 2 $100 (1 0.08) (1 0.08)
$100 (1 0.08)2
$116.64
(4.3)
The equations in the preceding example lead to a more general formula for
calculating future value.
The Equation for Future Value
The basic relationship in Equation 4.3 can be generalized to find the future value
after any number of periods. We use the following notation for the various inputs:
FVn future value at the end of period n
PV initial principal, or present value
i annual rate of interest paid. (Note: On financial calculators, I is typically used to represent this rate.)
n number of periods (typically years) that the money is left on deposit
The general equation for the future value at the end of period n is
FVn PV (1 i)n
(4.4)
A simple example will illustrate how to apply Equation 4.4.
EXAMPLE
Jane Farber places $800 in a savings account paying 6% interest compounded
annually. She wants to know how much money will be in the account at the end
of 5 years. Substituting PV $800, i 0.06, and n 5 into Equation 4.4 gives
the amount at the end of year 5.
FV5 $800 (1 0.06)5 $800 (1.338) $1,070.40
This analysis can be depicted on a time line as follows:
Time line for future
value of a single
amount ($800 initial
principal, earning 6%,
at the end of 5 years)
FV5 = $1,070.40
PV = $800
0
1
2
3
End of Year
4
5
CHAPTER 4
Time Value of Money
157
Using Computational Tools to Find Future Value
future value interest factor
The multiplier used to calculate,
at a specified interest rate, the
future value of a present amount
as of a given time.
Solving the equation in the preceding example involves raising 1.06 to the fifth
power. Using a future value interest table or a financial calculator or a computer
and spreadsheet greatly simplifies the calculation. A table that provides values for
(1 i)n in Equation 4.4 is included near the back of the book in Appendix Table
A–1. The value in each cell of the table is called the future value interest factor.
This factor is the multiplier used to calculate, at a specified interest rate, the
future value of a present amount as of a given time. The future value interest factor for an initial principal of $1 compounded at i percent for n periods is referred
to as FVIFi,n.
Future value interest factor FVIFi,n (1 i)n
(4.5)
By finding the intersection of the annual interest rate, i, and the appropriate
periods, n, you will find the future value interest factor that is relevant to a particular problem.1 Using FVIFi,n as the appropriate factor, we can rewrite the general equation for future value (Equation 4.4) as follows:
FVn PV (FVIFi,n)
(4.6)
This expression indicates that to find the future value at the end of period n of an
initial deposit, we have merely to multiply the initial deposit, PV, by the appropriate future value interest factor.2
EXAMPLE
Input
800
Function
PV
5
N
6
I
CPT
FV
Solution
1070.58
In the preceding example, Jane Farber placed $800 in her savings account at 6%
interest compounded annually and wishes to find out how much will be in the
account at the end of 5 years.
Table Use The future value interest factor for an initial principal of $1 on
deposit for 5 years at 6% interest compounded annually, FVIF6%, 5yrs, found in
Table A–1, is 1.338. Using Equation 4.6, $800 1.338 $1,070.40. Therefore,
the future value of Jane’s deposit at the end of year 5 will be $1,070.40.
Calculator Use3 The financial calculator can be used to calculate the future
value directly.4 First punch in $800 and depress PV; next punch in 5 and depress
N; then punch in 6 and depress I (which is equivalent to “i” in our notation)5;
finally, to calculate the future value, depress CPT and then FV. The future value
of $1,070.58 should appear on the calculator display as shown at the left. On
1. Although we commonly deal with years rather than periods, financial tables are frequently presented in terms of
periods to provide maximum flexibility.
2. Occasionally, you may want to estimate roughly how long a given sum must earn at a given annual rate to double
the amount. The Rule of 72 is used to make this estimate; dividing the annual rate of interest into 72 results in the
approximate number of periods it will take to double one’s money at the given rate. For example, to double one’s
money at a 10% annual rate of interest will take about 7.2 years (72 10 7.2). Looking at Table A–1, we can see
that the future value interest factor for 10% and 7 years is slightly below 2 (1.949); this approximation therefore
appears to be reasonably accurate.
3. Many calculators allow the user to set the number of payments per year. Most of these calculators are preset for
monthly payments—12 payments per year. Because we work primarily with annual payments—one payment per
year—it is important to be sure that your calculator is set for one payment per year. And although most calculators
are preset to recognize that all payments occur at the end of the period, it is important to make sure that your calculator is correctly set on the END mode. Consult the reference guide that accompanies your calculator for instructions for setting these values.
4. To avoid including previous data in current calculations, always clear all registers of your calculator before
inputting values and making each computation.
5. The known values can be punched into the calculator in any order; the order specified in this as well as other
demonstrations of calculator use included in this text merely reflects convenience and personal preference.
158
PART 2
Important Financial Concepts
many calculators, this value will be preceded by a minus sign (1,070.58). If a
minus sign appears on your calculator, ignore it here as well as in all other “Calculator Use” illustrations in this text.6
Because the calculator is more accurate than the future value factors, which
have been rounded to the nearest 0.001, a slight difference—in this case, $0.18—
will frequently exist between the values found by these alternative methods.
Clearly, the improved accuracy and ease of calculation tend to favor the use of
the calculator. (Note: In future examples of calculator use, we will use only a display similar to that shown on the preceding page. If you need a reminder of the
procedures involved, go back and review the preceding paragraph.)
Spreadsheet Use The future value of the single amount also can be calculated as
shown on the following Excel spreadsheet.
A Graphical View of Future Value
Remember that we measure future value at the end of the given period. Figure 4.5
illustrates the relationship among various interest rates, the number of periods
interest is earned, and the future value of one dollar. The figure shows that (1) the
Future Value
Relationship
Interest rates, time periods,
and future value of one
dollar
Future Value of One Dollar ($)
FIGURE 4.5
20%
30.00
25.00
15%
20.00
15.00
10%
10.00
5%
5.00
0%
1.00
0
2
4
6
8 10 12 14 16 18 20 22 24
Periods
6. The calculator differentiates inflows from outflows by preceding the outflows with a negative sign. For example,
in the problem just demonstrated, the $800 present value (PV), because it was keyed as a positive number (800), is
considered an inflow or deposit. Therefore, the calculated future value (FV) of 1,070.58 is preceded by a minus
sign to show that it is the resulting outflow or withdrawal. Had the $800 present value been keyed in as a negative
number (800), the future value of $1,070.58 would have been displayed as a positive number (1,070.58). Simply
stated, the cash flows— present value (PV) and future value (FV)—will have opposite signs.
CHAPTER 4
Time Value of Money
159
higher the interest rate, the higher the future value, and (2) the longer the period
of time, the higher the future value. Note that for an interest rate of 0 percent, the
future value always equals the present value ($1.00). But for any interest rate
greater than zero, the future value is greater than the present value of $1.00.
Present Value of a Single Amount
present value
The current dollar value of a
future amount—the amount of
money that would have to be
invested today at a given interest
rate over a specified period to
equal the future amount.
It is often useful to determine the value today of a future amount of money. For
example, how much would I have to deposit today into an account paying 7 percent annual interest in order to accumulate $3,000 at the end of 5 years? Present
value is the current dollar value of a future amount—the amount of money that
would have to be invested today at a given interest rate over a specified period to
equal the future amount. Present value depends largely on the investment opportunities and the point in time at which the amount is to be received. This section
explores the present value of a single amount.
The Concept of Present Value
discounting cash flows
The process of finding present
values; the inverse of compounding interest.
EXAMPLE
The process of finding present values is often referred to as discounting cash
flows. It is concerned with answering the following question: “If I can earn i
percent on my money, what is the most I would be willing to pay now for an
opportunity to receive FVn dollars n periods from today?”
This process is actually the inverse of compounding interest. Instead of finding the future value of present dollars invested at a given rate, discounting determines the present value of a future amount, assuming an opportunity to earn a
certain return on the money. This annual rate of return is variously referred to as
the discount rate, required return, cost of capital, and opportunity cost.7 These
terms will be used interchangeably in this text.
Paul Shorter has an opportunity to receive $300 one year from now. If he can
earn 6% on his investments in the normal course of events, what is the most he
should pay now for this opportunity? To answer this question, Paul must determine how many dollars he would have to invest at 6% today to have $300 one
year from now. Letting PV equal this unknown amount and using the same notation as in the future value discussion, we have
PV (1 0.06) $300
(4.7)
Solving Equation 4.7 for PV gives us Equation 4.8:
$300
PV (1 0.06)
$283.02
(4.8)
The value today (“present value”) of $300 received one year from today,
given an opportunity cost of 6%, is $283.02. That is, investing $283.02 today at
the 6% opportunity cost would result in $300 at the end of one year.
7. The theoretical underpinning of this “required return” is introduced in Chapter 5 and further refined in subsequent chapters.
160
PART 2
Important Financial Concepts
The Equation for Present Value
The present value of a future amount can be found mathematically by solving
Equation 4.4 for PV. In other words, the present value, PV, of some future
amount, FVn, to be received n periods from now, assuming an opportunity cost of
i, is calculated as follows:
FVn
1
PV FVn (1 i)n
(1 i)n
(4.9)
Note the similarity between this general equation for present value and the
equation in the preceding example (Equation 4.8). Let’s use this equation in an
example.
EXAMPLE
Pam Valenti wishes to find the present value of $1,700 that will be received 8
years from now. Pam’s opportunity cost is 8%. Substituting FV8 $1,700, n 8,
and i 0.08 into Equation 4.9 yields Equation 4.10:
$1,700
$1,700
PV $918.42
(1 0.08)8
1.851
(4.10)
The following time line shows this analysis.
Time line for present
value of a single
amount ($1,700 future
amount, discounted at
8%, from the end of
8 years)
0
1
2
3
End of Year
4
5
6
7
8
FV8 = $1,700
PV = $918.42
Using Computational Tools to Find Present Value
present value interest factor
The multiplier used to calculate,
at a specified discount rate, the
present value of an amount to be
received in a future period.
The present value calculation can be simplified by using a present value interest
factor. This factor is the multiplier used to calculate, at a specified discount rate,
the present value of an amount to be received in a future period. The present
value interest factor for the present value of $1 discounted at i percent for n periods is referred to as PVIFi,n.
1
Present value interest factor PVIFi,n (1 i)n
(4.11)
Appendix Table A–2 presents present value interest factors for $1. By letting
PVIFi,n represent the appropriate factor, we can rewrite the general equation for
present value (Equation 4.9) as follows:
PV FVn (PVIFi,n)
(4.12)
This expression indicates that to find the present value of an amount to be received in a future period, n, we have merely to multiply the future amount, FVn ,
by the appropriate present value interest factor.
CHAPTER 4
EXAMPLE
Input
1700
Function
FV
8
N
I
8
CPT
PV
Solution
918.46
Time Value of Money
161
As noted, Pam Valenti wishes to find the present value of $1,700 to be received 8
years from now, assuming an 8% opportunity cost.
Table Use The present value interest factor for 8% and 8 years, PVIF8%, 8 yrs,
found in Table A–2, is 0.540. Using Equation 4.12, $1,700 0.540 $918. The
present value of the $1,700 Pam expects to receive in 8 years is $918.
Calculator Use Using the calculator’s financial functions and the inputs shown
at the left, you should find the present value to be $918.46. The value obtained
with the calculator is more accurate than the values found using the equation or
the table, although for the purposes of this text, these differences are
insignificant.
Spreadsheet Use The present value of the single future amount also can be calculated as shown on the following Excel spreadsheet.
A Graphical View of Present Value
FIGURE 4.6
Present Value
Relationship
Discount rates, time periods,
and present value of one
dollar
Present Value of One Dollar ($)
Remember that present value calculations assume that the future values are measured at the end of the given period. The relationships among the factors in a
present value calculation are illustrated in Figure 4.6. The figure clearly shows
that, everything else being equal, (1) the higher the discount rate, the lower the
1.00
0%
0.75
0.50
5%
0.25
10%
15%
20%
0
2
4
6
8 10 12 14 16 18 20 22 24
Periods
162
PART 2
Important Financial Concepts
present value, and (2) the longer the period of time, the lower the present value.
Also note that given a discount rate of 0 percent, the present value always equals
the future value ($1.00). But for any discount rate greater than zero, the present
value is less than the future value of $1.00.
Comparing Present Value and Future Value
We will close this section with some important observations about present values. One is that the expression for the present value interest factor for i percent
and n periods, 1/(1 i)n, is the inverse of the future value interest factor for i
percent and n periods, (1 i)n. You can confirm this very simply: Divide a present value interest factor for i percent and n periods, PVIFi,n, given in Table A–2,
into 1.0, and compare the resulting value to the future value interest factor given
in Table A–1 for i percent and n periods, FVIFi,n,. The two values should be
equivalent.
Second, because of the relationship between present value interest factors
and future value interest factors, we can find the present value interest factors
given a table of future value interest factors, and vice versa. For example, the
future value interest factor (from Table A–1) for 10 percent and 5 periods is
1.611. Dividing this value into 1.0 yields 0.621, which is the present value interest factor (given in Table A–2) for 10 percent and 5 periods.
Review Questions
4–3
4–4
4–5
4–6
4–7
LG3
How is the compounding process related to the payment of interest on
savings? What is the general equation for future value?
What effect would a decrease in the interest rate have on the future value
of a deposit? What effect would an increase in the holding period have on
future value?
What is meant by “the present value of a future amount”? What is the
general equation for present value?
What effect does increasing the required return have on the present value
of a future amount? Why?
How are present value and future value calculations related?
4.3 Annuities
annuity
A stream of equal periodic cash
flows, over a specified time
period. These cash flows can be
inflows of returns earned on
investments or outflows of funds
invested to earn future returns.
How much will you have at the end of 5 years if your employer withholds and
invests $1,000 of your year-end bonus at the end of each of the next 5 years, guaranteeing you a 9 percent annual rate of return? How much would you pay today,
given that you can earn 7 percent on low-risk investments, to receive a guaranteed
$3,000 at the end of each of the next 20 years? To answer these questions, you
need to understand the application of the time value of money to annuities.
An annuity is a stream of equal periodic cash flows, over a specified time
period. These cash flows are usually annual but can occur at other intervals, such
as monthly (rent, car payments). The cash flows in an annuity can be inflows (the
CHAPTER 4
ordinary annuity
An annuity for which the cash
flow occurs at the end of each
period.
annuity due
An annuity for which the cash
flow occurs at the beginning of
each period.
EXAMPLE
Time Value of Money
163
$3,000 received at the end of each of the next 20 years) or outflows (the $1,000
invested at the end of each of the next 5 years).
Types of Annuities
There are two basic types of annuities. For an ordinary annuity, the cash flow
occurs at the end of each period. For an annuity due, the cash flow occurs at the
beginning of each period.
Fran Abrams is choosing which of two annuities to receive. Both are 5-year,
$1,000 annuities; annuity A is an ordinary annuity, and annuity B is an annuity
due. To better understand the difference between these annuities, she has listed
their cash flows in Table 4.1. Note that the amount of each annuity totals
$5,000. The two annuities differ in the timing of their cash flows: The cash flows
are received sooner with the annuity due than with the ordinary annuity.
Although the cash flows of both annuities in Table 4.1 total $5,000, the
annuity due would have a higher future value than the ordinary annuity, because
each of its five annual cash flows can earn interest for one year more than each of
the ordinary annuity’s cash flows. In general, as will be demonstrated later in this
chapter, both the future value and the present value of an annuity due are always
greater than the future value and the present value, respectively, of an otherwise
identical ordinary annuity.
Because ordinary annuities are more frequently used in finance, unless otherwise specified, the term annuity is intended throughout this book to refer to
ordinary annuities.
Finding the Future Value of an Ordinary Annuity
The calculations required to find the future value of an ordinary annuity are illustrated in the following example.
TABLE 4.1
Comparison of Ordinary Annuity
and Annuity Due Cash Flows
($1,000, 5 Years)
Annual cash flows
End of yeara
0
Annuity A (ordinary)
0
$1,000
1
1,000
1,000
2
1,000
1,000
3
1,000
1,000
4
1,000
1,000
5
1
,0
0
0
$
5
,
0
0
0
0
$
5
,
0
0
0
Totals
$
Annuity B (annuity due)
aThe ends of years 0, 1, 2, 3, 4, and 5 are equivalent to the beginnings of years
1, 2, 3, 4, 5, and 6, respectively.
164
PART 2
Important Financial Concepts
EXAMPLE
Fran Abrams wishes to determine how much money she will have at the end of 5
years if he chooses annuity A, the ordinary annuity. It represents deposits of
$1,000 annually, at the end of each of the next 5 years, into a savings account
paying 7% annual interest. This situation is depicted on the following time line:
$1,311
1,225
1,145
1,070
1,000
$5,751 Future Value
Time line for future
value of an ordinary
annuity ($1,000 end-ofyear deposit, earning
7%, at the end of 5
years)
0
$1,000
$1,000
$1,000
$1,000
$1,000
1
2
3
4
5
End of Year
As the figure shows, at the end of year 5, Fran will have $5,751 in her account.
Note that because the deposits are made at the end of the year, the first deposit
will earn interest for 4 years, the second for 3 years, and so on.
Using Computational Tools to Find
the Future Value of an Ordinary Annuity
future value interest factor
for an ordinary annuity
The multiplier used to calculate
the future value of an ordinary
annuity at a specified interest
rate over a given period of time.
Annuity calculations can be simplified by using an interest table or a financial calculator or a computer and spreadsheet. A table for the future value of a $1 ordinary annuity is given in Appendix Table A–3. The factors in the table are derived
by summing the future value interest factors for the appropriate number of years.
For example, the factor for the annuity in the preceding example is the sum of the
factors for the five years (years 4 through 0): 1.311 1.225 1.145 1.070 1.000 5.751. Because the deposits occur at the end of each year, they will earn
interest from the end of the year in which each occurs to the end of year 5. Therefore, the first deposit earns interest for 4 years (end of year 1 through end of year
5), and the last deposit earns interest for zero years. The future value interest factor for zero years at any interest rate, FVIFi,0, is 1.000, as we have noted. The formula for the future value interest factor for an ordinary annuity when interest is
compounded annually at i percent for n periods, FVIFAi,n, is8
n
FVIFAi,n (1 i)t1
(4.13)
t1
8. A mathematical expression that can be applied to calculate the future value interest factor for an ordinary annuity
more efficiently is
1
FVIFAi,n [(1 i)n 1]
i
(4.13a)
The use of this expression is especially attractive in the absence of the appropriate financial tables and of any financial calculator or personal computer and spreadsheet.
CHAPTER 4
Time Value of Money
165
This factor is the multiplier used to calculate the future value of an ordinary
annuity at a specified interest rate over a given period of time.
Using FVAn for the future value of an n-year annuity, PMT for the amount to
be deposited annually at the end of each year, and FVIFAi,n for the appropriate
future value interest factor for a one-dollar ordinary annuity compounded at i
percent for n years, we can express the relationship among these variables alternatively as
FVAn PMT (FVIFAi,n)
(4.14)
The following example illustrates this calculation using a table, a calculator, and
a spreadsheet.
EXAMPLE
Input
1000
Function
PMT
5
N
7
I
CPT
FV
Solution
5750.74
As noted earlier, Fran Abrams wishes to find the future value (FVAn) at the end
of 5 years (n) of an annual end-of-year deposit of $1,000 (PMT) into an account
paying 7% annual interest (i) during the next 5 years.
Table Use The future value interest factor for an ordinary 5-year annuity at 7%
(FVIFA7%,5yrs), found in Table A–3, is 5.751. Using Equation 4.14, the $1,000
deposit 5.751 results in a future value for the annuity of $5,751.
Calculator Use Using the calculator inputs shown at the left, you will find the
future value of the ordinary annuity to be $5,750.74, a slightly more precise
answer than that found using the table.
Spreadsheet Use The future value of the ordinary annuity also can be calculated
as shown on the following Excel spreadsheet.
Finding the Present Value of an Ordinary Annuity
Quite often in finance, there is a need to find the present value of a stream of cash
flows to be received in future periods. An annuity is, of course, a stream of equal
periodic cash flows. (We’ll explore the case of mixed streams of cash flows in a
later section.) The method for finding the present value of an ordinary annuity is
similar to the method just discussed. There are long and short methods for making this calculation.
166
PART 2
Important Financial Concepts
EXAMPLE
Time line for present
value of an ordinary
annuity ($700 endof-year cash flows,
discounted at 8%,
over 5 years)
Braden Company, a small producer of plastic toys, wants to determine the most it
should pay to purchase a particular ordinary annuity. The annuity consists of
cash flows of $700 at the end of each year for 5 years. The firm requires the
annuity to provide a minimum return of 8%. This situation is depicted on the following time line:
0
1
2
$700
$700
End of Year
3
$700
4
5
$700
$700
$ 648.20
599.90
555.80
514.50
476.70
Present Value $2,795.10
Table 4.2 shows the long method for finding the present value of the annuity.
This method involves finding the present value of each payment and summing
them. This procedure yields a present value of $2,795.10.
Using Computational Tools to Find
the Present Value of an Ordinary Annuity
Annuity calculations can be simplified by using an interest table for the present
value of an annuity, a financial calculator, or a computer and spreadsheet. The
values for the present value of a $1 ordinary annuity are given in Appendix Table
A–4. The factors in the table are derived by summing the present value interest
TABLE 4.2
The Long Method for Finding
the Present Value of an
Ordinary Annuity
Year (n)
Cash flow
(1)
PVIF8%,na
(2)
Present value
[(1) (2)]
(3)
1
$700
0.926
$ 648.20
2
700
0.857
599.90
3
700
0.794
555.80
4
700
0.735
514.50
5
700
0.681
aPresent
476.70
Present value of annuity $2,795.10
value interest factors at 8% are from Table A–2.
CHAPTER 4
present value interest factor
for an ordinary annuity
The multiplier used to calculate
the present value of an ordinary
annuity at a specified discount
rate over a given period of time.
Time Value of Money
167
factors (in Table A–2) for the appropriate number of years at the given discount
rate. The formula for the present value interest factor for an ordinary annuity
with cash flows that are discounted at i percent for n periods, PVIFAi,n, is9
n
1
PVIFAi,n t
t1 (1 i)
(4.15)
This factor is the multiplier used to calculate the present value of an ordinary
annuity at a specified discount rate over a given period of time.
By letting PVAn equal the present value of an n-year ordinary annuity, letting
PMT equal the amount to be received annually at the end of each year, and letting PVIFAi,n represent the appropriate present value interest factor for a onedollar ordinary annuity discounted at i percent for n years, we can express the
relationship among these variables as
PVAn PMT (PVIFAi,n)
(4.16)
The following example illustrates this calculation using a table, a calculator, and
a spreadsheet.
EXAMPLE
Input
700
Function
PMT
5
N
8
I
CPT
PV
Solution
2794.90
Braden Company, as we have noted, wants to find the present value of a 5-year
ordinary annuity of $700, assuming an 8% opportunity cost.
Table Use The present value interest factor for an ordinary annuity at 8% for
5 years (PVIFA8%,5yrs), found in Table A–4, is 3.993. If we use Equation 4.16,
$700 annuity 3.993 results in a present value of $2,795.10.
Calculator Use Using the calculator’s inputs shown at the left, you will find the
present value of the ordinary annuity to be $2,794.90. The value obtained with
the calculator is more accurate than those found using the equation or the table.
Spreadsheet Use The present value of the ordinary annuity also can be calculated as shown on the following Excel spreadsheet.
9. A mathematical expression that can be applied to calculate the present value interest factor for an ordinary annuity more efficiently is
1
1
PVIFAi,n 1 i
(1 i)n
(4.15a)
The use of this expression is especially attractive in the absence of the appropriate financial tables and of any financial calculator or personal computer and spreadsheet.
168
PART 2
Important Financial Concepts
FOCUS ON PRACTICE
In Practice
Farewell to the Good “Olds” Days
For almost 3,000 car dealers,
December 2000 marked the end of
a 103-year era. General Motors announced that it would phase out
the unprofitable Oldsmobile brand
with the production of the 2004
model year—or sooner if demand
dropped too low. GM entered into
a major negotiation with owners of
Oldsmobile dealerships to determine the value of the brand’s dealerships and how to compensate
franchise owners for their investment. Closing out the Oldsmobile
name over the 4-year period could
cost GM $2 billion or more, depending on real estate values, the
future value of lost profits, and
leasehold improvements.
As they waited to see what
would happen, many Olds dealers
voiced concern about recent
expenditures to upgrade their
facilities to comply with GM standards. They also wondered about
the franchise’s viability during the
phase-out. After all, how many
customers will want to buy
Oldsmobiles, knowing the brand is
being discontinued?
In a letter to dealers, William
J. Lovejoy, GM’s North American
group sales vice president, says
GM will repurchase all unsold
Olds vehicles regardless of model
year, as well as unused and undamaged parts; will remove and
buy back all signage; and will
buy back essential tools but let
dealers retain tools exclusively
designed for Olds products. By
mid-2001, GM had offered Olds
dealers cash to surrender franchises, up to about $2,900 per Olds
sold during the best year between
1998 and 2000.
Cal Woodward, a CPA with
expertise in dealership accounting, worked with the negotiating
team to develop an appropriate list
of requests. He recommended that
they include reimbursement for the
present value of future profits they
will lose as a result of the closing
of their Oldsmobile franchises and
for reduced profits or losses in the
interim period. Mr. Woodward
suggested that they use a 9 percent interest factor to calculate
the present value of 10 years of incremental franchise profits.
Sources: Adapted from James R. Healey and
Earle Eldridge, “Good Olds Days Are
Numbered,” USA Today (September 10,
2001), p. 6B; Maynard M. Gordon, “What’s an
Olds Franchise Worth?” Ward’s Dealer
Business (February 1, 2001), p. 40; Al
Rothenberg, “No More Merry Oldsmobile,”
Ward’s Auto World (March 1, 2001), p. 86.
Finding the Future Value of an Annuity Due
We now turn our attention to annuities due. Remember that the cash flows of an
annuity due occur at the start of the period. A simple conversion is applied to use
the future value interest factors for an ordinary annuity (in Table A–3) with
annuities due. Equation 4.17 presents this conversion:
FVIFAi,n (annuity due) FVIFAi,n (1 i)
(4.17)
This equation says that the future value interest factor for an annuity due can
be found merely by multiplying the future value interest factor for an ordinary
annuity at the same percent and number of periods by (1 i). Why is this adjustment necessary? Because each cash flow of an annuity due earns interest for one
year more than an ordinary annuity (from the start to the end of the year). Multiplying FVIFAi,n by (1 i) simply adds an additional year’s interest to each annuity cash flow. The following example demonstrates how to find the future value
of an annuity due.
EXAMPLE
Remember from an earlier example that Fran Abrams wanted to choose
between an ordinary annuity and an annuity due, both offering similar terms
except for the timing of cash flows. We calculated the future value of the ordinary annuity in the example on page 164. We now will calculate the future value
of the annuity due, using the cash flows represented by annuity B in Table 4.1
(page 163).
CHAPTER 4
Time Value of Money
169
Table Use Substituting i 7% and n 5 years into Equation 4.17, with the aid
of the appropriate interest factor from Table A–3, we get
FVIFA7%,5yrs (annuity due) FVIFA7%,5yrs (1 0.07)
5.751 1.07 6.154
Then, substituting PMT $1,000 and FVIFA7%, 5 yrs (annuity due) 6.154 into
Equation 4.14, we get a future value for the annuity due:
Note: Switch calculator
to BEGIN mode.
Input
1000
Function
PMT
5
N
7
I
CPT
FV
Solution
6153.29
FVA5 $1,000 6.154 $6,154
Calculator Use Before using your calculator to find the future value of an annuity due, depending on the specific calculator, you must either switch it to BEGIN
mode or use the DUE key. Then, using the inputs shown at the left, you will find
the future value of the annuity due to be $6,153.29. (Note: Because we nearly
always assume end-of-period cash flows, be sure to switch your calculator back
to END mode when you have completed your annuity-due calculations.)
Spreadsheet Use The future value of the annuity due also can be calculated as
shown on the following Excel spreadsheet.
Comparison of an Annuity Due
with an Ordinary Annuity Future Value
The future value of an annuity due is always greater than the future value of an
otherwise identical ordinary annuity. We can see this by comparing the future
values at the end of year 5 of Fran Abrams’s two annuities:
Ordinary annuity $5,750.74
Annuity due $6,153.29
Because the cash flow of the annuity due occurs at the beginning of the period
rather than at the end, its future value is greater. In the example, Fran would earn
about $400 more with the annuity due.
Finding the Present Value of an Annuity Due
We can also find the present value of an annuity due. This calculation can be easily performed by adjusting the ordinary annuity calculation. Because the cash
flows of an annuity due occur at the beginning rather than the end of the period,
to find their present value, each annuity due cash flow is discounted back one less
year than for an ordinary annuity. A simple conversion can be applied to use the
present value interest factors for an ordinary annuity (in Table A–4) with annuities due.
PVIFA i,n (annuity due) PVIFA i,n (1 i)
(4.18)
170
PART 2
Important Financial Concepts
The equation indicates that the present value interest factor for an annuity
due can be obtained by multiplying the present value interest factor for an ordinary annuity at the same percent and number of periods by (1 i). This conversion adjusts for the fact that each cash flow of an annuity due is discounted back
one less year than a comparable ordinary annuity Multiplying PVIFAi,n by (1 i)
effectively adds back one year of interest to each annuity cash flow. Adding back
one year of interest to each cash flow in effect reduces by 1 the number of years
each annuity cash flow is discounted.
EXAMPLE
In the earlier example of Braden Company on page 166, we found the present
value of Braden’s $700, 5-year ordinary annuity discounted at 8% to be about
$2,795. If we now assume that Braden’s $700 annual cash flow occurs at the
start of each year and is thereby an annuity due, we can calculate its present value
using a table, a calculator, or a spreadsheet.
Table Use Substituting i 8% and n 5 years into Equation 4.18, with the aid
of the appropriate interest factor from Table A–4, we get
PVIFA8%,5yrs (annuity due) PVIFA8%,5yrs (1 0.08)
3.993 1.08 4.312
Then, substituting PMT $700 and PVIFA8%,5yrs (annuity due) 4.312 into
Equation 4.16, we get a present value for the annuity due:
Note: Switch calculator
to BEGIN mode.
Input
700
Function
PMT
5
N
8
I
CPT
PV
Solution
3018.49
PVA5 $700 4.312 $3,018.40
Calculator Use Before using your calculator to find the present value of an
annuity due, depending on the specifics of your calculator, you must either switch
it to BEGIN mode or use the DUE key. Then, using the inputs shown at the left,
you will find the present value of the annuity due to be $3,018.49. (Note: Because
we nearly always assume end-of-period cash flows, be sure to switch your calculator back to END mode when you have completed your annuity-due calculations.)
Spreadsheet Use The present value of the annuity due also can be calculated as
shown on the following Excel spreadsheet.
Comparison of an Annuity Due
with an Ordinary Annuity Present Value
The present value of an annuity due is always greater than the present value of an
otherwise identical ordinary annuity. We can see this by comparing the present
values of the Braden Company’s two annuities:
Ordinary annuity $2,794.90
Annuity due $3,018.49
CHAPTER 4
Time Value of Money
171
Because the cash flow of the annuity due occurs at the beginning of the period
rather than at the end, its present value is greater. In the example, Braden Company would realize about $200 more in present value with the annuity due.
Finding the Present Value of a Perpetuity
perpetuity
An annuity with an infinite life,
providing continual annual cash
flow.
A perpetuity is an annuity with an infinite life—in other words, an annuity that
never stops providing its holder with a cash flow at the end of each year (for
example, the right to receive $500 at the end of each year forever).
It is sometimes necessary to find the present value of a perpetuity. The present
value interest factor for a perpetuity discounted at the rate i is
1
PVIFAi, i
(4.19)
As the equation shows, the appropriate factor, PVIFAi, , is found simply by
dividing the discount rate, i (stated as a decimal), into 1. The validity of this
method can be seen by looking at the factors in Table A–4 for 8, 10, 20, and
40 percent: As the number of periods (typically years) approaches 50, these factors approach the values calculated using Equation 4.19: 1 0.08 12.50;
1 0.10 10.00; 1 0.20 5.00; and 1 0.40 2.50.
EXAMPLE
Ross Clark wishes to endow a chair in finance at his alma mater. The university
indicated that it requires $200,000 per year to support the chair, and the endowment would earn 10% per year. To determine the amount Ross must give the
university to fund the chair, we must determine the present value of a $200,000
perpetuity discounted at 10%. The appropriate present value interest factor can
be found by dividing 1 by 0.10, as noted in Equation 4.19. Substituting the
resulting factor, 10, and the amount of the perpetuity, PMT $200,000, into
Equation 4.16 results in a present value of $2,000,000 for the perpetuity. In other
words, to generate $200,000 every year for an indefinite period requires
$2,000,000 today if Ross Clark’s alma mater can earn 10% on its investments. If
the university earns 10% interest annually on the $2,000,000, it can withdraw
$200,000 a year indefinitely without touching the initial $2,000,000, which
would never be drawn upon.
Review Questions
4–8
What is the difference between an ordinary annuity and an annuity due?
Which always has greater future value and present value for identical
annuities and interest rates? Why?
4–9 What are the most efficient ways to calculate the present value of an ordinary annuity? What is the relationship between the PVIF and PVIFA
interest factors given in Tables A–2 and A–4, respectively?
4–10 How can the future value interest factors for an ordinary annuity be modified to find the future value of an annuity due?
4–11 How can the present value interest factors for an ordinary annuity be
modified to find the present value of an annuity due?
4–12 What is a perpetuity? How can the present value interest factor for such a
stream of cash flows be determined?
172
PART 2
Important Financial Concepts
LG4
4.4 Mixed Streams
mixed stream
A stream of unequal periodic
cash flows that reflect no particular pattern.
Two basic types of cash flow streams are possible: the annuity and the mixed
stream. Whereas an annuity is a pattern of equal periodic cash flows, a mixed
stream is a stream of unequal periodic cash flows that reflect no particular pattern. Financial managers frequently need to evaluate opportunities that are
expected to provide mixed streams of cash flows. Here we consider both the
future value and the present value of mixed streams.
Future Value of a Mixed Stream
Determining the future value of a mixed stream of cash flows is straightforward.
We determine the future value of each cash flow at the specified future date and
then add all the individual future values to find the total future value.
EXAMPLE
Shrell Industries, a cabinet manufacturer, expects to receive the following mixed
stream of cash flows over the next 5 years from one of its small customers.
End of year
Cash flow
1
2
3
4
5
$11,500
14,000
12,900
16,000
18,000
If Shrell expects to earn 8% on its investments, how much will it accumulate by
the end of year 5 if it immediately invests these cash flows when they are
received? This situation is depicted on the following time time:
$15,640.00
17,640.00
15,041.40
17,280.00
18,000.00
$83,601.40 Future Value
Time line for future
value of a mixed
stream (end-of-year
cash flows, compounded at 8% to
the end of year 5)
0
$11,500
$14,000
1
2
$12,900
$16,000
$18,000
3
4
5
End of Year
Table Use To solve this problem, we determine the future value of each cash
flow compounded at 8% for the appropriate number of years. Note that the first
cash flow of $11,500, received at the end of year 1, will earn interest for 4 years
(end of year 1 through end of year 5); the second cash flow of $14,000, received at
the end of year 2, will earn interest for 3 years (end of year 2 through end of year
5); and so on. The sum of the individual end-of-year-5 future values is the future
value of the mixed cash flow stream. The future value interest factors required are
CHAPTER 4
TABLE 4.3
Time Value of Money
173
Future Value of a Mixed Stream
of Cash Flows
Year
Cash flow
(1)
1
2
3
4
5
$11,500
14,000
12,900
16,000
18,000
Number of years
earning interest (n)
(2)
FVIF8%,na
(2)
514
1.360
523
1.260
532
1.166
541
1.080
550
1.000b
Future value of mixed stream
Future value
[(1) (3)]
(4)
$15,640.00
17,640.00
15,041.40
17,280.00
18,000.00
$83,601.40
aFuture
value interest factors at 8% are from Table A–1.
future value of the end-of-year-5 deposit at the end of year 5 is its present value because it earns
interest for zero years and (1 0.08)0 1.000.
bThe
those shown in Table A–1. Table 4.3 presents the calculations needed to find the
future value of the cash flow stream, which turns out to be $83,601.40.
Calculator Use You can use your calculator to find the future value of each
individual cash flow, as demonstrated earlier (page 157), and then sum the future
values, to get the future value of the stream. Unfortunately, unless you can program your calculator, most calculators lack a function that would allow you to
input all of the cash flows, specify the interest rate, and directly calculate the
future value of the entire cash flow stream. Had you used your calculator to find
the individual cash flow future values and then summed them, the future value of
Shrell Industries’ cash flow stream at the end of year 5 would have been
$83,608.15, a more precise value than the one obtained by using a financial table.
Spreadsheet Use The future value of the mixed stream also can be calculated as
shown on the following Excel spreadsheet.
If Shrell Industries invests at 8% interest the cash flows received from its customer over the next 5 years, the company will accumulate about $83,600 by the
end of year 5.
174
PART 2
Important Financial Concepts
Present Value of a Mixed Stream
Finding the present value of a mixed stream of cash flows is similar to finding the
future value of a mixed stream. We determine the present value of each future
amount and then add all the individual present values together to find the total
present value.
EXAMPLE
Frey Company, a shoe manufacturer, has been offered an opportunity to receive
the following mixed stream of cash flows over the next 5 years:
End of year
Cash flow
1
$400
2
800
3
500
4
400
5
300
If the firm must earn at least 9% on its investments, what is the most it should
pay for this opportunity? This situation is depicted on the following time line:
Time line for present
value of a mixed
stream (end-of-year
cash flows, discounted
at 9% over the corresponding number of
years)
0
1
2
$400
$800
End of Year
3
$500
4
5
$400
$300
$ 366.80
673.60
386.00
283.20
195.00
Present Value $1,904.60
Table Use To solve this problem, determine the present value of each cash flow
discounted at 9% for the appropriate number of years. The sum of these individual values is the present value of the total stream. The present value interest factors required are those shown in Table A–2. Table 4.4 presents the calculations
needed to find the present value of the cash flow stream, which turns out to be
$1,904.60.
Calculator Use You can use a calculator to find the present value of each individual cash flow, as demonstrated earlier (page 161), and then sum the present
values, to get the present value of the stream. However, most financial calculators
have a function that allows you to punch in all cash flows, specify the discount
rate, and then directly calculate the present value of the entire cash flow stream.
Because calculators provide solutions more precise than those based on rounded
CHAPTER 4
TABLE 4.4
Time Value of Money
Present Value of a Mixed
Stream of Cash Flows
Year (n)
Cash flow
(1)
PVIF9%,na
(2)
Present value
[(1) (2)]
(3)
1
$400
0.917
$ 366.80
2
800
0.842
673.60
3
500
0.772
386.00
4
400
0.708
283.20
5
300
0.650
aPresent
175
195.00
Present value of mixed stream $1,904.60
value interest factors at 9% are from Table A–2.
table factors, the present value of Frey Company’s cash flow stream found using
a calculator is $1,904.76, which is close to the $1,904.60 value calculated before.
Spreadsheet Use The present value of the mixed stream of future cash flows
also can be calculated as shown on the following Excel spreadsheet.
Paying about $1,905 would provide exactly a 9% return. Frey should pay no
more than that amount for the opportunity to receive these cash flows.
Review Question
4–13 How is the future value of a mixed stream of cash flows calculated? How
is the present value of a mixed stream of cash flows calculated?
176
PART 2
Important Financial Concepts
LG5
4.5 Compounding Interest More
Frequently Than Annually
Interest is often compounded more frequently than once a year. Savings institutions compound interest semiannually, quarterly, monthly, weekly, daily, or even
continuously. This section discusses various issues and techniques related to these
more frequent compounding intervals.
Semiannual Compounding
semiannual compounding
Compounding of interest over
two periods within the year.
Semiannual compounding of interest involves two compounding periods within
the year. Instead of the stated interest rate being paid once a year, one-half of the
stated interest rate is paid twice a year.
EXAMPLE
Fred Moreno has decided to invest $100 in a savings account paying 8% interest
compounded semiannually. If he leaves his money in the account for 24 months
(2 years), he will be paid 4% interest compounded over four periods, each of
which is 6 months long. Table 4.5 uses interest factors to show that at the end of
12 months (1 year) with 8% semiannual compounding, Fred will have $108.16;
at the end of 24 months (2 years), he will have $116.99.
Quarterly Compounding
quarterly compounding
Compounding of interest over
four periods within the year.
EXAMPLE
Quarterly compounding of interest involves four compounding periods within
the year. One-fourth of the stated interest rate is paid four times a year.
Fred Moreno has found an institution that will pay him 8% interest compounded
quarterly. If he leaves his money in this account for 24 months (2 years), he will be
paid 2% interest compounded over eight periods, each of which is 3 months long.
Table 4.6 uses interest factors to show the amount Fred will have at the end of
each period. At the end of 12 months (1 year), with 8% quarterly compounding,
Fred will have $108.24; at the end of 24 months (2 years), he will have $117.16.
TABLE 4.5
Period
The Future Value from Investing
$100 at 8% Interest Compounded
Semiannually Over 24 Months
(2 Years)
Beginning
principal
(1)
Future value
interest factor
(2)
Future value at end
of period [(1) (2)]
(3)
6 months
$100.00
1.04
$104.00
12 months
104.00
1.04
108.16
18 months
108.16
1.04
112.49
24 months
112.49
1.04
116.99
CHAPTER 4
TABLE 4.6
Time Value of Money
The Future Value from Investing
$100 at 8% Interest Compounded
Quarterly Over 24 Months
(2 Years)
Beginning
principal
(1)
Future value
interest factor
(2)
Future value at end
of period [(1) (2)]
(3)
3 months
$100.00
1.02
$102.00
6 months
102.00
1.02
104.04
9 months
104.04
1.02
106.12
12 months
106.12
1.02
108.24
15 months
108.24
1.02
110.40
18 months
110.40
1.02
112.61
21 months
112.61
1.02
114.86
24 months
114.86
1.02
117.16
Period
TABLE 4.7
177
The Future Value at the End of
Years 1 and 2 from Investing $100
at 8% Interest, Given Various
Compounding Periods
Compounding period
End of year
Annual
Semiannual
Quarterly
1
$108.00
$108.16
$108.24
2
116.64
116.99
117.16
Table 4.7 compares values for Fred Moreno’s $100 at the end of years 1 and
2 given annual, semiannual, and quarterly compounding periods at the 8 percent
rate. As shown, the more frequently interest is compounded, the greater the
amount of money accumulated. This is true for any interest rate for any period
of time.
A General Equation for Compounding
More Frequently Than Annually
The formula for annual compounding (Equation 4.4) can be rewritten for use
when compounding takes place more frequently. If m equals the number of times
per year interest is compounded, the formula for annual compounding can be
rewritten as
i
FVn PV 1 m
mn
(4.20)
178
PART 2
Important Financial Concepts
If m 1, Equation 4.20 reduces to Equation 4.4. Thus, if interest is compounded annually (once a year), Equation 4.20 will provide the same result as
Equation 4.4. The general use of Equation 4.20 can be illustrated with a simple
example.
EXAMPLE
The preceding examples calculated the amount that Fred Moreno would have at
the end of 2 years if he deposited $100 at 8% interest compounded semiannually
and compounded quarterly. For semiannual compounding, m would equal 2 in
Equation 4.20; for quarterly compounding, m would equal 4. Substituting the
appropriate values for semiannual and quarterly compounding into Equation
4.20, we find that
1. For semiannual compounding:
0.08
FV2 $100 1 2
22
$100 (1 0.04)4 $116.99
2. For quarterly compounding:
0.08
FV2 $100 1 4
42
$100 (1 0.02)8 $117.16
These results agree with the values for FV2 in Tables 4.5 and 4.6.
If the interest were compounded monthly, weekly, or daily, m would equal 12,
52, or 365, respectively.
Using Computational Tools for Compounding
More Frequently Than Annually
We can use the future value interest factors for one dollar, given in Table A–1,
when interest is compounded m times each year. Instead of indexing the table
for i percent and n years, as we do when interest is compounded annually, we
index it for (i m) percent and (m n) periods. However, the table is less
useful, because it includes only selected rates for a limited number of periods.
Instead, a financial calculator or a computer and spreadsheet is typically
required.
EXAMPLE
Fred Moreno wished to find the future value of $100 invested at 8% interest
compounded both semiannually and quarterly for 2 years. The number of compounding periods, m, the interest rate, and the number of periods used in each
case, along with the future value interest factor, are as follows:
Compounding
period
m
Interest rate
(i ÷ m)
Periods
(m n)
Future value interest factor
from Table A–1
Semiannual
2
8% 2 4%
224
1.170
Quarterly
4
8% 4 2%
428
1.172
CHAPTER 4
Input
100
Function
PV
4
N
4
I
CPT
FV
Solution
116.99
Input
100
Function
PV
8
N
2
I
Time Value of Money
179
Table Use Multiplying each of the future value interest factors by the initial
$100 deposit results in a value of $117.00 (1.170 $100) for semiannual compounding and a value of $117.20 (1.172 $100) for quarterly compounding.
Calculator Use If the calculator were used for the semiannual compounding
calculation, the number of periods would be 4 and the interest rate would be
4%. The future value of $116.99 will appear on the calculator display as
shown at the top left.
For the quarterly compounding case, the number of periods would be 8 and
the interest rate would be 2%. The future value of $117.17 will appear on the calculator display as shown in the second display at the left.
Spreadsheet Use The future value of the single amount with semiannual and
quarterly compounding also can be calculated as shown on the following Excel
spreadsheet.
CPT
FV
Solution
117.17
Comparing the calculator, table, and spreadsheet values, we can see that the
calculator and spreadsheet values agree generally with the values in Table 4.7 but
are more precise because the table factors have been rounded.
Continuous Compounding
continuous compounding
Compounding of interest an
infinite number of times per year
at intervals of microseconds.
In the extreme case, interest can be compounded continuously. Continuous
compounding involves compounding over every microsecond—the smallest time
period imaginable. In this case, m in Equation 4.20 would approach infinity.
Through the use of calculus, we know that as m approaches infinity, the equation
becomes
FVn (continuous compounding) PV (ein)
(4.21)
where e is the exponential function10, which has a value of 2.7183. The future
value interest factor for continuous compounding is therefore
FVIFi,n (continuous compounding) ein
(4.22)
10. Most calculators have the exponential function, typically noted by ex, built into them. The use of this key is especially helpful in calculating future value when interest is compounded continuously.
180
PART 2
Important Financial Concepts
EXAMPLE
To find the value at the end of 2 years (n 2) of Fred Moreno’s $100 deposit
(PV $100) in an account paying 8% annual interest (i 0.08) compounded
continuously, we can substitute into Equation 4.21:
FV2 (continuous compounding) $100 e0.082
$100 2.71830.16
$100 1.1735 $117.35
Input
0.16
Function
2nd
ex
Calculator Use To find this value using the calculator, you need first to find the
value of e0.16 by punching in 0.16 and then pressing 2nd and then ex to get 1.1735.
Next multiply this value by $100 to get the future value of $117.35 as shown at the
left. (Note: On some calculators, you may not have to press 2nd before pressing ex.)
1.1735
100
Spreadsheet Use The future value of the single amount with continuous compounding also can be calculated as shown on the following Excel spreadsheet.
Solution
117.35
The future value with continuous compounding therefore equals $117.35. As
expected, the continuously compounded value is larger than the future value of
interest compounded semiannually ($116.99) or quarterly ($117.16). Continuous compounding offers the largest amount that would result from compounding
interest more frequently than annually.
Nominal and Effective Annual Rates of Interest
nominal (stated) annual rate
Contractual annual rate of
interest charged by a lender or
promised by a borrower.
effective (true) annual rate (EAR)
The annual rate of interest
actually paid or earned.
Both businesses and investors need to make objective comparisons of loan costs
or investment returns over different compounding periods. In order to put interest rates on a common basis, to allow comparison, we distinguish between nominal and effective annual rates. The nominal, or stated, annual rate is the contractual annual rate of interest charged by a lender or promised by a borrower. The
effective, or true, annual rate (EAR) is the annual rate of interest actually paid or
earned. The effective annual rate reflects the impact of compounding frequency,
whereas the nominal annual rate does not.
Using the notation introduced earlier, we can calculate the effective annual
rate, EAR, by substituting values for the nominal annual rate, i, and the compounding frequency, m, into Equation 4.23:
i m
1
m
EAR 1 We can apply this equation using data from preceding examples.
(4.23)
CHAPTER 4
EXAMPLE
181
Time Value of Money
Fred Moreno wishes to find the effective annual rate associated with an 8% nominal annual rate (i 0.08) when interest is compounded (1) annually (m 1);
(2) semiannually (m 2); and (3) quarterly (m 4). Substituting these values into
Equation 4.23, we get
1. For annual compounding:
0.08
EAR 1 1
1
1 (1 0.08)1 1 1 0.08 1 0.08 8%
2. For semiannual compounding:
0.08
EAR 1 2
2
1 (1 0.04)2 1 1.0816 1 0.0816 8.16%
3. For quarterly compounding:
0.08
EAR 1 4
4
1 (1 0.02)4 1 1.0824 1 0.0824 8.24%
These values demonstrate two important points: The first is that nominal and
effective annual rates are equivalent for annual compounding. The second is that
the effective annual rate increases with increasing compounding frequency, up to
a limit that occurs with continuous compounding.11
annual percentage rate (APR)
The nominal annual rate of
interest, found by multiplying the
periodic rate by the number of
periods in 1 year, that must be
disclosed to consumers on credit
cards and loans as a result of
“truth-in-lending laws.”
annual percentage yield (APY)
The effective annual rate of
interest that must be disclosed to
consumers by banks on their
savings products as a result of
“truth-in-savings laws.”
At the consumer level, “truth-in-lending laws” require disclosure on credit
card and loan agreements of the annual percentage rate (APR). The APR is the
nominal annual rate found by multiplying the periodic rate by the number of
periods in one year. For example, a bank credit card that charges 1 1/2 percent per
month (the periodic rate) would have an APR of 18% (1.5% per month 12
months per year).
“Truth-in-savings laws,” on the other hand, require banks to quote the
annual percentage yield (APY) on their savings products. The APY is the effective
annual rate a savings product pays. For example, a savings account that pays 0.5
percent per month would have an APY of 6.17 percent [(1.005)12 1].
Quoting loan interest rates at their lower nominal annual rate (the APR) and
savings interest rates at the higher effective annual rate (the APY) offers two
advantages: It tends to standardize disclosure to consumers, and it enables financial institutions to quote the most attractive interest rates: low loan rates and high
savings rates.
11. The effective annual rate for this extreme case can be found by using the following equation:
EAR (continuous compounding) e k 1
(4.23a)
For the 8% nominal annual rate (k 0.08), substitution into Equation 4.23a results in an effective
annual rate of
e0.08 1 1.0833 1 0.0833 8.33%
in the case of continuous compounding. This is the highest effective annual rate attainable with an
8% nominal rate.
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Review Questions
4–14 What effect does compounding interest more frequently than annually
have on (a) future value and (b) the effective annual rate (EAR)? Why?
4–15 How does the future value of a deposit subject to continuous compounding compare to the value obtained by annual compounding?
4–16 Differentiate between a nominal annual rate and an effective annual rate
(EAR). Define annual percentage rate (APR) and annual percentage yield
(APY).
LG6
4.6 Special Applications of Time Value
Future value and present value techniques have a number of important applications in finance. We’ll study four of them in this section: (1) deposits needed to
accumulate a future sum, (2) loan amortization, (3) interest or growth rates, and
(4) finding an unknown number of periods.
Deposits Needed to Accumulate a Future Sum
Suppose you want to buy a house 5 years from now, and you estimate that an initial down payment of $20,000 will be required at that time. To accumulate the
20,000, you will wish to make equal annual end-of-year deposits into an account
paying annual interest of 6 percent. The solution to this problem is closely related
to the process of finding the future value of an annuity. You must determine what
size annuity will result in a single amount equal to $20,000 at the end of year 5.
Earlier in the chapter we found the future value of an n-year ordinary annuity, FVAn, by multiplying the annual deposit, PMT, by the appropriate interest
factor, FVIFAi,n. The relationship of the three variables was defined by Equation
4.14, which is repeated here as Equation 4.24:
FVAn PMT (FVIFAi,n)
(4.24)
We can find the annual deposit required to accumulate FVAn dollars by solving Equation 4.24 for PMT. Isolating PMT on the left side of the equation gives us
FVAn
PMT FVIFAi,n
(4.25)
Once this is done, we have only to substitute the known values of FVAn and
FVIFAi,n into the right side of the equation to find the annual deposit required.
EXAMPLE
As just stated, you want to determine the equal annual end-of-year deposits
required to accumulate $20,000 at the end of 5 years, given an interest rate
of 6%.
Table Use Table A–3 indicates that the future value interest factor for an
ordinary annuity at 6% for 5 years (FVIFA6%,5yrs) is 5.637. Substituting
CHAPTER 4
Input
20,000
Function
FV
5
N
6
I
CPT
PMT
Solution
3547.93
Time Value of Money
183
FVA5 $20,000 and FVIFA6%,5yrs 5.637 into Equation 4.25 yields an annual
required deposit, PMT, of $3,547.99. Thus if $3,547.99 is deposited at the end of
each year for 5 years at 6% interest, there will be $20,000 in the account at the
end of the 5 years.
Calculator Use Using the calculator inputs shown at the left, you will find the
annual deposit amount to be $3,547.93. Note that this value, except for a slight
rounding difference, agrees with the value found by using Table A–3.
Spreadsheet Use The annual deposit needed to accumulate the future sum also
can be calculated as shown on the following Excel spreadsheet.
Loan Amortization
loan amortization
The determination of the equal
periodic loan payments
necessary to provide a lender
with a specified interest return
and to repay the loan principal
over a specified period.
loan amortization schedule
A schedule of equal payments to
repay a loan. It shows the allocation of each loan payment to
interest and principal.
The term loan amortization refers to the computation of equal periodic loan payments. These payments provide a lender with a specified interest return and
repay the loan principal over a specified period. The loan amortization process
involves finding the future payments, over the term of the loan, whose present
value at the loan interest rate equals the amount of initial principal borrowed.
Lenders use a loan amortization schedule to determine these payment amounts
and the allocation of each payment to interest and principal. In the case of home
mortgages, these tables are used to find the equal monthly payments necessary to
amortize, or pay off, the mortgage at a specified interest rate over a 15- to 30year period.
Amortizing a loan actually involves creating an annuity out of a present
amount. For example, say you borrow $6,000 at 10 percent and agree to make
equal annual end-of-year payments over 4 years. To find the size of the payments,
the lender determines the amount of a 4-year annuity discounted at 10 percent
that has a present value of $6,000. This process is actually the inverse of finding
the present value of an annuity.
Earlier in the chapter, we found the present value, PVAn, of an n-year annuity by multiplying the annual amount, PMT, by the present value interest factor
for an annuity, PVIFAi,n. This relationship, which was originally expressed as
Equation 4.16, is repeated here as Equation 4.26:
PVAn PMT (PVIFAi,n)
(4.26)
184
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Important Financial Concepts
FOCUS ON PRACTICE
In Practice
Time Is on Your Side
For many years, the 30-year fixedrate mortgage was the traditional
choice of home buyers. In recent
years, however, more homeowners are choosing fixed-rate mortgages with a 15-year term when
they buy a new home or refinance
their current residence. They are
often pleasantly surprised to discover that they can pay off the
loan in half the time with a monthly
payment that is only about 25 percent higher. Not only will they own
the home free and clear sooner,
but they pay considerably less interest over the life of the loan.
For example, assume you
need a $200,000 mortgage and
can borrow at fixed rates. The
shorter loan would carry a lower
rate (because it presents less risk
for the lender). The accompanying
table shows how the two mortgages compare: The extra $431 a
month, or a total of $77,580, saves
$157,765 in interest payments over
Term
Rate
Monthly principal
and interest
Total interest paid
over the term of the loan
15 years
6.50%
$1,742
$113,625
30 years
6.85%
$1,311
$271,390
the life of the loan, for net savings
of $80,185!
Why isn’t everyone rushing to
take out a shorter mortgage? Many
homeowners either can’t afford
the higher monthly payment or
would rather have the extra spending money now. Others hope to do
even better by investing the difference themselves. Suppose you invested $431 each month in a mutual fund with an average annual
return of 7 percent. At the end of
15 years, your $77,580 investment
would have grown to $136,611, or
$59,031 more than you contributed!
However, many people lack the
self-discipline to save rather than
spend that money. For them, the
15-year mortgage represents
forced savings.
Yet another option is to make
additional principal payments
whenever possible. This shortens
the life of the loan without committing you to the higher payments. By
paying just $100 more each month,
you can shorten the life of a 30year mortgage to 24 1/4 years, with
attendant interest savings.
Sources: Daniela Deane, “Adding Up Pros,
Cons of 15-Year Loans,” Washington Post
(October 13, 2001), p. H7; Henry Savage, “Is
15-Year Loan Right for You?” Washington
Times (June 22, 2001), p. F22; Carlos Tejada,
“Sweet Fifteen: Shorter Mortgages Are Gaining Support,” Wall Street Journal (September 17, 1998), p. C1; Ann Tergesen, “It’s Time
to Refinance . . . Again,” Business Week
(November 2, 1998), pp. 134–135.
To find the equal annual payment required to pay off, or amortize, the loan,
PVAn, over a certain number of years at a specified interest rate, we need to solve
Equation 4.26 for PMT. Isolating PMT on the left side of the equation gives us
PVAn
PMT PVIFAi,n
(4.27)
Once this is done, we have only to substitute the known values into the righthand
side of the equation to find the annual payment required.
EXAMPLE
As just stated, you want to determine the equal annual end-of-year payments necessary to amortize fully a $6,000, 10% loan over 4 years.
Table Use Table A–4 indicates that the present value interest factor for an
annuity corresponding to 10% and 4 years (PVIFA10%,4yrs) is 3.170. Substituting
PVA4 $6,000 and PVIFA10%,4yrs 3.170 into Equation 4.27 and solving for
PMT yield an annual loan payment of $1,892.74. Thus to repay the interest and
principal on a $6,000, 10%, 4-year loan, equal annual end-of-year payments of
$1,892.74 are necessary.
CHAPTER 4
Input
6000
Function
PV
4
N
10
I
CPT
PMT
Solution
1892.82
Time Value of Money
185
Calculator Use Using the calculator inputs shown at the left, you will find the
annual payment amount to be $1,892.82. Except for a slight rounding difference,
this value agrees with the table solution.
The allocation of each loan payment to interest and principal can be seen in
columns 3 and 4 of the loan amortization schedule in Table 4.8 at the top of page
186. The portion of each payment that represents interest (column 3) declines
over the repayment period, and the portion going to principal repayment (column 4) increases. This pattern is typical of amortized loans; as the principal is
reduced, the interest component declines, leaving a larger portion of each subsequent loan payment to repay principal.
Spreadsheet Use The annual payment to repay the loan also can be calculated
as shown on the first Excel spreadsheet. The amortization schedule allocating
each loan payment to interest and principal also can be calculated precisely as
shown on the second spreadsheet.
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Important Financial Concepts
TABLE 4.8
Loan Amortization Schedule ($6,000
Principal, 10% Interest, 4-Year Repayment
Period)
Payments
End
of
year
Beginningof-year
principal
(1)
Loan
payment
(2)
Interest
[0.10 (2)]
(3)
Principal
[(1) (3)]
(4)
End-of-year
principal
[(2) (4)]
(5)
1
$6,000.00
$1,892.74
$600.00
$1,292.74
$4,707.26
2
4,707.26
1,892.74
470.73
1,422.01
3,285.25
3
3,285.25
1,892.74
328.53
1,564.21
1,721.04
4
1,721.04
1,892.74
172.10
1,720.64
—a
aBecause
of rounding, a slight difference ($0.40) exists between the beginning-of-year-4 principal
(in column 1) and the year-4 principal payment (in column 4).
Interest or Growth Rates
It is often necessary to calculate the compound annual interest or growth rate
(that is, the annual rate of change in values) of a series of cash flows. Examples
include finding the interest rate on a loan, the rate of growth in sales, and the rate
of growth in earnings. In doing this, we can use either future value or present
value interest factors. The use of present value interest factors is described in this
section. The simplest situation is one in which a person wishes to find the rate of
interest or growth in a series of cash flows.12
EXAMPLE
Ray Noble wishes to find the rate of interest or growth reflected in the stream of
cash flows he received from a real estate investment over the period 1999 through
2003. The following table lists those cash flows:
Year
Cash flow
2003
$1,520
2002
1,440
2001
2000
1999
}4
}3
1,370
}2
1,300
}1
1,250
By using the first year (1999) as a base year, we see that interest has been earned
(or growth experienced) for 4 years.
Table Use The first step in finding the interest or growth rate is to divide the
amount received in the earliest year (PV) by the amount received in the latest year
(FVn). Looking back at Equation 4.12, we see that this results in the present value
12. Because the calculations required for finding interest rates and growth rates, given the series of cash flows, are
the same, this section refers to the calculations as those required to find interest or growth rates.
CHAPTER 4
Time Value of Money
187
interest factor for a single amount for 4 years, PVIFi,4yrs, which is 0.822
($1,250 $1,520). The interest rate in Table A–2 associated with the factor closest to 0.822 for 4 years is the interest or growth rate of Ray’s cash flows. In the
row for year 4 in Table A–2, the factor for 5 percent is 0.823—almost exactly the
0.822 value. Therefore, the interest or growth rate of the given cash flows is
approximately (to the nearest whole percent) 5%.13
Input
1250
Function
PV
1520
FV
4
N
CPT
I
Solution
5.01
Calculator Use Using the calculator, we treat the earliest value as a present
value, PV, and the latest value as a future value, FVn. (Note: Most calculators
require either the PV or the FV value to be input as a negative number to calculate an unknown interest or growth rate. That approach is used here.) Using
the inputs shown at the left, you will find the interest or growth rate to be
5.01%, which is consistent with, but more precise than, the value found using
Table A–2.
Spreadsheet Use The interest or growth rate for the series of cash flows also can
be calculated as shown on the following Excel spreadsheet.
Another type of interest-rate problem involves finding the interest rate associated with an annuity, or equal-payment loan.
EXAMPLE
Jan Jacobs can borrow $2,000 to be repaid in equal annual end-of-year amounts
of $514.14 for the next 5 years. She wants to find the interest rate on this loan.
Table Use Substituting PVA5 $2,000 and PMT $514.14 into Equation 4.26
and rearranging the equation to solve for PVIFAi,5yrs, we get
PVA5
$2,000
PVIFAi,5yrs 3.890
PMT
$514.14
(4.28)
13. To obtain more precise estimates of interest or growth rates, interpolation—a mathematical technique for estimating unknown intermediate values—can be applied. For information on how to interpolate a more precise answer
in this example, see the book’s home page at www.aw.com/gitman.
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PART 2
Important Financial Concepts
Input
514.14
Function
PMT
2000
PV
5
N
CPT
I
Solution
9.00
The interest rate for 5 years associated with the annuity factor closest to 3.890 in
Table A–4 is 9%. Therefore, the interest rate on the loan is approximately (to the
nearest whole percent) 9%.
Calculator Use (Note: Most calculators require either the PMT or the PV value
to be input as a negative number in order to calculate an unknown interest rate
on an equal-payment loan. That approach is used here.) Using the inputs shown
at the left, you will find the interest rate to be 9.00%, which is consistent with the
value found using Table A–4.
Spreadsheet Use The interest or growth rate for the annuity also can be calculated as shown on the following Excel spreadsheet.
Finding an Unknown Number of Periods
Sometimes it is necessary to calculate the number of time periods needed to generate a given amount of cash flow from an initial amount. Here we briefly consider this calculation for both single amounts and annuities. This simplest case is
when a person wishes to determine the number of periods, n, it will take for an
initial deposit, PV, to grow to a specified future amount, FVn , given a stated
interest rate, i.
EXAMPLE
Ann Bates wishes to determine the number of years it will take for her initial
$1,000 deposit, earning 8% annual interest, to grow to equal $2,500. Simply
stated, at an 8% annual rate of interest, how many years, n, will it take for Ann’s
$1,000, PV, to grow to $2,500, FVn?
Table Use In a manner similar to our approach above to finding an unknown
interest or growth rate in a series of cash flows, we begin by dividing the amount
deposited in the earliest year by the amount received in the latest year. This
results in the present value interest factor for 8% and n years, PVIF8%,n, which is
0.400 ($1,000 $2,500). The number of years (periods) in Table A–2 associated
with the factor closest to 0.400 for an 8% interest rate is the number of years
required for $1,000 to grow into $2,500 at 8%. In the 8% column of Table A–2,
the factor for 12 years is 0.397—almost exactly the 0.400 value. Therefore, the
number of years necessary for the $1,000 to grow to a future value of $2,500 at
8% is approximately (to the nearest year) 12.
CHAPTER 4
Input
1000
Function
PV
2500
FV
8
I
CPT
N
Solution
11.91
Time Value of Money
189
Calculator Use Using the calculator, we treat the initial value as the present
value, PV, and the latest value as the future value, FVn. (Note: Most calculators
require either the PV or the FV value to be input as a negative number to calculate an unknown number of periods. That approach is used here.) Using the
inputs shown at the left, we find the number of periods to be 11.91 years,
which is consistent with, but more precise than, the value found above using
Table A–2.
Spreadsheet Use The number of years for the present value to grow to a specified
future value also can be calculated as shown on the following Excel spreadsheet.
Another type of number-of-periods problem involves finding the number of
periods associated with an annuity. Occasionally we wish to find the unknown
life, n, of an annuity, PMT, that is intended to achieve a specific objective, such as
repaying a loan of a given amount, PVAn, with a stated interest rate, i.
EXAMPLE
Bill Smart can borrow $25,000 at an 11% annual interest rate; equal, annual
end-of-year payments of $4,800 are required. He wishes to determine how long it
will take to fully repay the loan. In other words, he wishes to determine how
many years, n, it will take to repay the $25,000, 11% loan, PVAn, if the payments of $4,800, PMT, are made at the end of each year.
Table Use Substituting PVAn $25,000 and PMT $4,800 into Equation 4.26
and rearranging the equation to solve PVIFA11%,n yrs, we get
PVAn
$25,000
PVIFA11%,n yrs 5.208
PMT
$4,800
Input
4800
Function
PMT
25000
PV
11
The number of periods for an 11% interest rate associated with the annuity factor closest to 5.208 in Table A–4 is 8 years. Therefore, the number of periods
necessary to repay the loan fully is approximately (to the nearest year) 8 years.
I
CPT
N
Solution
8.15
(4.29)
Calculator Use (Note: Most calculators require either the PV or the PMT value
to be input as a negative number in order to calculate an unknown number of
periods. That approach is used here.) Using the inputs shown at the left, you will
find the number of periods to be 8.15, which is consistent with the value found
using Table A–4.
190
PART 2
Important Financial Concepts
Spreadsheet Use The number of years to pay off the loan also can be calculated
as shown on the following Excel spreadsheet.
Review Questions
4–17 How can you determine the size of the equal annual end-of-period deposits
necessary to accumulate a certain future sum at the end of a specified future
period at a given annual interest rate?
4–18 Describe the procedure used to amortize a loan into a series of equal periodic payments.
4–19 Which present value interest factors would be used to find (a) the growth
rate associated with a series of cash flows and (b) the interest rate associated with an equal-payment loan?
4–20 How can you determine the unknown number of periods when you know
the present and future values—single amount or annuity—and the applicable rate of interest?
S U M M A RY
FOCUS ON VALUE
Time value of money is an important tool that financial managers and other market participants use to assess the impact of proposed actions. Because firms have long lives and their
important decisions affect their long-term cash flows, the effective application of timevalue-of-money techniques is extremely important. Time value techniques enable financial
managers to evaluate cash flows occurring at different times in order to combine, compare,
and evaluate them and link them to the firm’s overall goal of share price maximization. It
will become clear in Chapters 6 and 7 that the application of time value techniques is a key
part of the value determination process. Using them, we can measure the firm’s value and
evaluate the impact that various events and decisions might have on it. Clearly, an understanding of time-value-of-money techniques and an ability to apply them are needed in
order to make intelligent value-creating decisions.
CHAPTER 4
Time Value of Money
191
REVIEW OF LEARNING GOALS
Discuss the role of time value in finance, the use
of computational tools, and the basic patterns
of cash flow. Financial managers and investors use
time-value-of-money techniques when assessing the
value of the expected cash flow streams associated
with investment alternatives. Alternatives can be assessed by either compounding to find future value or
discounting to find present value. Because they are
at time zero when making decisions, financial managers rely primarily on present value techniques.
Financial tables, financial calculators, and computers and spreadsheets can streamline the application
of time value techniques. The cash flow of a firm
can be described by its pattern—single amount, annuity, or mixed stream.
LG1
count rate to represent the present value interest
factor. The interest factor formulas and basic equations for the future value and the present value of
both an ordinary annuity and an annuity due, and
the present value of a perpetuity, are given in
Table 4.9.
Calculate both the future value and the present
value of a mixed stream of cash flows. A mixed
stream of cash flows is a stream of unequal periodic
cash flows that reflect no particular pattern. The
future value of a mixed stream of cash flows is the
sum of the future values of each individual cash
flow. Similarly, the present value of a mixed stream
of cash flows is the sum of the present values of the
individual cash flows.
LG4
Understand the concepts of future and present
value, their calculation for single amounts, and
the relationship of present value to future value.
Future value relies on compound interest to measure future amounts: The initial principal or deposit
in one period, along with the interest earned on it,
becomes the beginning principal of the following
period. The present value of a future amount is the
amount of money today that is equivalent to the
given future amount, considering the return that
can be earned on the current money. Present value
is the inverse future value. The interest factor formulas and basic equations for both the future value
and the present value of a single amount are given
in Table 4.9.
Understand the effect that compounding interest more frequently than annually has on future
value and on the effective annual rate of interest.
Interest can be compounded at intervals ranging
from annually to daily, and even continuously. The
more often interest is compounded, the larger the
future amount that will be accumulated, and the
higher the effective, or true, annual rate (EAR). The
annual percentage rate (APR)—a nominal annual
rate—is quoted on credit cards and loans. The annual percentage yield (APY)—an effective annual
rate—is quoted on savings products. The interest
factor formulas for compounding more frequently
than annually are given in Table 4.9.
Find the future value and the present value of
both an ordinary annuity and an annuity due,
and find the present value of a perpetuity. An annuity is a pattern of equal periodic cash flows. For
an ordinary annuity, the cash flows occur at the
end of the period. For an annuity due, cash flows
occur at the beginning of the period. The future
value of an ordinary annuity can be found by using
the future value interest factor for an annuity; the
present value of an ordinary annuity can be found
by using the present value interest factor for an annuity. A simple conversion can be applied to use
the future value and present value interest factors
for an ordinary annuity to find, respectively, the
future value and the present value of an annuity
due. The present value of a perpetuity—an infinitelived annuity—is found using 1 divided by the dis-
Describe the procedures involved in (1) determining deposits to accumulate a future sum,
(2) loan amortization, (3) finding interest or growth
rates, and (4) finding an unknown number of periods. The periodic deposit to accumulate a given future sum can be found by solving the equation for
the future value of an annuity for the annual payment. A loan can be amortized into equal periodic
payments by solving the equation for the present
value of an annuity for the periodic payment. Interest or growth rates can be estimated by finding the
unknown interest rate in the equation for the present value of a single amount or an annuity. Similarly, an unknown number of periods can be estimated by finding the unknown number of periods
in the equation for the present value of a single
amount or an annuity.
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LG5
LG6
192
PART 2
Important Financial Concepts
TABLE 4.9
Summary of Key Definitions, Formulas, and
Equations for Time Value of Money
Definitions of variables
e exponential function 2.7183
EAR effective annual rate
FVn future value or amount at the end of period n
FVAn future value of an n-year annuity
i annual rate of interest
m number of times per year interest is compounded
n number of periods—typically years—over which money earns a return
PMT amount deposited or received annually at the end of each year
PV initial principal or present value
PVAn present value of an n-year annuity
t period number index
Interest factor formulas
Future value of a single amount with annual compounding:
FVIFi,n (1 i)n
[Eq. 4.5; factors in Table A–1]
Present value of a single amount:
1
PVIFi,n (1 i)n
Future value of an ordinary annuity:
[Eq. 4.11; factors in Table A–2]
n
FVIFAi,n (1 i)t1
t=1
[Eq. 4.13; factors in Table A–3]
Present value of an ordinary annuity:
n
1
t
PVIFAi,n t=1 (1 i)
Future value of an annuity due:
FVIFAi,n (annuity due) FVIFAi,n (1 i)
[Eq. 4.15; factors in Table A–4]
[Eq. 4.17]
Present value of an annuity due:
PVIFAi,n (annuity due) PVIFAi,n (1 i)
Present value of a perpetuity:
1
PVIFAi,∞ i
[Eq. 4.18]
[Eq. 4.19]
Future value with compounding more frequently than annually:
i mn
FVIFi,n 1 [Eq. 4.20]
m
for continuous compounding, m ∞:
FVIFi,n (continuous compounding) ei n
to find the effective annual rate:
i m
EAR 1 1
m
[Eq. 4.22]
[Eq. 4.23]
Basic equations
Future value (single amount):
Present value (single amount):
FVn PV (FVIFi,n)
PV FVn (PVIFi,n)
[Eq. 4.6]
[Eq. 4.12]
Future value (annuity):
FVAn PMT (FVIFAi,n)
[Eq. 4.14]
Present value (annuity):
PVAn PMT (PVIFAi,n)
[Eq. 4.16]
CHAPTER 4
SELF-TEST PROBLEMS
LG2
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LG3
Time Value of Money
193
(Solutions in Appendix B)
LG5
ST 4–1
Future values for various compounding frequencies Delia Martin has $10,000
that she can deposit in any of three savings accounts for a 3-year period. Bank A
compounds interest on an annual basis, bank B compounds interest twice each
year, and bank C compounds interest each quarter. All three banks have a stated
annual interest rate of 4%.
a. What amount would Ms. Martin have at the end of the third year, leaving all
interest paid on deposit, in each bank?
b. What effective annual rate (EAR) would she earn in each of the banks?
c. On the basis of your findings in parts a and b, which bank should Ms.
Martin deal with? Why?
d. If a fourth bank (bank D), also with a 4% stated interest rate, compounds
interest continuously, how much would Ms. Martin have at the end of the
third year? Does this alternative change your recommendation in part c?
Explain why or why not.
LG3
ST 4–2
Future values of annuities Ramesh Abdul wishes to choose the better of two
equally costly cash flow streams: annuity X and annuity Y. X is an annuity due
with a cash inflow of $9,000 for each of 6 years. Y is an ordinary annuity with a
cash inflow of $10,000 for each of 6 years. Assume that Ramesh can earn 15%
on his investments.
a. On a purely subjective basis, which annuity do you think is more attractive?
Why?
b. Find the future value at the end of year 6, FVA6, for both annuity X and
annuity Y.
c. Use your finding in part b to indicate which annuity is more attractive. Why?
Compare your finding to your subjective response in part a.
LG4
ST 4–3
Present values of single amounts and streams You have a choice of accepting
either of two 5-year cash flow streams or single amounts. One cash flow stream
is an ordinary annuity, and the other is a mixed stream. You may accept alternative A or B—either as a cash flow stream or as a single amount. Given the cash
flow stream and single amounts associated with each (see the accompanying
table), and assuming a 9% opportunity cost, which alternative (A or B) and in
which form (cash flow stream or single amount) would you prefer?
Cash flow stream
End of year
Alternative A
Alternative B
1
$700
$1,100
2
700
900
3
700
700
4
700
500
5
700
300
Single amount
At time zero
$2,825
$2,800
194
PART 2
LG6
Important Financial Concepts
ST 4–4
Deposits needed to accumulate a future sum Judi Janson wishes to accumulate
$8,000 by the end of 5 years by making equal annual end-of-year deposits over
the next 5 years. If Judi can earn 7% on her investments, how much must she
deposit at the end of each year to meet this goal?
LG1
4–1
Using a time line The financial manager at Starbuck Industries is considering
an investment that requires an initial outlay of $25,000 and is expected to result
in cash inflows of $3,000 at the end of year 1, $6,000 at the end of years 2 and
3, $10,000 at the end of year 4, $8,000 at the end of year 5, and $7,000 at the
end of year 6.
a. Draw and label a time line depicting the cash flows associated with Starbuck
Industries’ proposed investment.
b. Use arrows to demonstrate, on the time line in part a, how compounding
to find future value can be used to measure all cash flows at the end of
year 6.
c. Use arrows to demonstrate, on the time line in part b, how discounting to
find present value can be used to measure all cash flows at time zero.
d. Which of the approaches—future value or present value—do financial managers rely on most often for decision making? Why?
LG2
4–2
Future value calculation Without referring to tables or to the preprogrammed
function on your financial calculator, use the basic formula for future value
along with the given interest rate, i, and the number of periods, n, to calculate
the future value interest factor in each of the cases shown in the following table.
Compare the calculated value to the value in Appendix Table A–1.
PROBLEMS
LG2
4–3
Case
Interest rate, i
Number of periods, n
A
12%
2
B
6
3
C
9
2
D
3
4
Future value tables Use the future value interest factors in Appendix Table A–1
in each of the cases shown in the following table to estimate, to the nearest year,
how long it would take an initial deposit, assuming no withdrawals,
a. To double.
b. To quadruple.
Case
A
Interest rate
7%
B
40
C
20
D
10
CHAPTER 4
LG2
4–4
Time Value of Money
195
Future values For each of the cases shown in the following table, calculate the
future value of the single cash flow deposited today that will be available at the
end of the deposit period if the interest is compounded annually at the rate specified over the given period.
Case
A
Single cash flow
$
200
Interest rate
5%
Deposit period (years)
20
B
4,500
8
7
C
10,000
9
10
D
25,000
10
12
E
37,000
11
5
F
40,000
12
9
LG2
4–5
Future value You have $1,500 to invest today at 7% interest compounded
annually.
a. Find how much you will have accumulated in the account at the end of
(1) 3 years, (2) 6 years, and (3) 9 years.
b. Use your findings in part a to calculate the amount of interest earned in
(1) the first 3 years (years 1 to 3), (2) the second 3 years (years 4 to 6), and
(3) the third 3 years (years 7 to 9).
c. Compare and contrast your findings in part b. Explain why the amount of
interest earned increases in each succeeding 3-year period.
LG2
4–6
Inflation and future value As part of your financial planning, you wish to purchase a new car exactly 5 years from today. The car you wish to purchase costs
$14,000 today, and your research indicates that its price will increase by 2% to
4% per year over the next 5 years.
a. Estimate the price of the car at the end of 5 years if inflation is (1) 2% per
year, and (2) 4% per year.
b. How much more expensive will the car be if the rate of inflation is 4% rather
than 2%?
LG2
4–7
Future value and time You can deposit $10,000 into an account paying 9%
annual interest either today or exactly 10 years from today. How much better
off will you be at the end of 40 years if you decide to make the initial deposit
today rather than 10 years from today?
LG2
4–8
Future value calculation Misty need to have $15,000 at the end of 5 years
in order to fulfill her goal of purchasing a small sailboat. She is willing to
invest the funds as a single amount today but wonders what sort of investment
return she will need to earn. Use your calculator or the time value tables to figure out the approximate annually compounded rate of return needed in each of
these cases:
a. Misty can invest $10,200 today.
b. Misty can invest $8,150 today.
c. Misty can invest $7,150 today.
196
PART 2
Important Financial Concepts
LG2
LG2
4–9
Single-payment loan repayment A person borrows $200 to be repaid in 8 years
with 14% annually compounded interest. The loan may be repaid at the end of
any earlier year with no prepayment penalty.
a. What amount will be due if the loan is repaid at the end of year 1?
b. What is the repayment at the end of year 4?
c. What amount is due at the end of the eighth year?
4–10
Present value calculation Without referring to tables or to the preprogrammed
function on your financial calculator, use the basic formula for present value,
along with the given opportunity cost, i, and the number of periods, n, to calculate the present value interest factor in each of the cases shown in the accompanying table. Compare the calculated value to the table value.
Case
Opportunity
cost, i
A
LG2
4–11
Number of
periods, n
2%
4
B
10
2
C
5
3
D
13
2
Present values For each of the cases shown in the following table, calculate the
present value of the cash flow, discounting at the rate given and assuming that
the cash flow is received at the end of the period noted.
Case
Single cash
flow
Discount rate
End of
period (years)
A
$ 7,000
12%
4
B
28,000
8
20
C
10,000
14
12
D
150,000
11
6
E
45,000
20
8
LG2
4–12
Present value concept Answer each of the following questions.
a. What single investment made today, earning 12% annual interest, will be
worth $6,000 at the end of 6 years?
b. What is the present value of $6,000 to be received at the end of 6 years if the
discount rate is 12%?
c. What is the most you would pay today for a promise to repay you $6,000 at
the end of 6 years if your opportunity cost is 12%?
d. Compare, contrast, and discuss your findings in parts a through c.
LG2
4–13
Present value Jim Nance has been offered a future payment of $500 three years
from today. If his opportunity cost is 7% compounded annually, what value
should he place on this opportunity today? What is the most he should pay to
purchase this payment today?
CHAPTER 4
Time Value of Money
197
LG2
4–14
Present value An Iowa state savings bond can be converted to $100 at maturity
6 years from purchase. If the state bonds are to be competitive with U.S. Savings
Bonds, which pay 8% annual interest (compounded annually), at what price
must the state sell its bonds? Assume no cash payments on savings bonds prior
to redemption.
LG2
4–15
Present value and discount rates You just won a lottery that promises to pay
you $1,000,000 exactly 10 years from today. Because the $1,000,000 payment
is guaranteed by the state in which you live, opportunities exist to sell the claim
today for an immediate single cash payment.
a. What is the least you will sell your claim for if you can earn the following
rates of return on similar-risk investments during the 10-year period?
(1) 6%
(2) 9%
(3) 12%
b. Rework part a under the assumption that the $1,000,000 payment will be
received in 15 rather than 10 years.
c. On the basis of your findings in parts a and b, discuss the effect of both the
size of the rate of return and the time until receipt of payment on the present
value of a future sum.
LG2
4–16
Present value comparisons of single amounts In exchange for a $20,000 payment today, a well-known company will allow you to choose one of the alternatives shown in the following table. Your opportunity cost is 11%.
Alternative
Single amount
A
$28,500 at end of 3 years
B
$54,000 at end of 9 years
C
$160,000 at end of 20 years
a. Find the value today of each alternative.
b. Are all the alternatives acceptable, i.e., worth $20,000 today?
c. Which alternative, if any, will you take?
LG2
4–17
Cash flow investment decision Tom Alexander has an opportunity to purchase
any of the investments shown in the following table. The purchase price, the
amount of the single cash inflow, and its year of receipt are given for each investment. Which purchase recommendations would you make, assuming that Tom
can earn 10% on his investments?
Investment
Price
Single cash inflow
Year of receipt
A
$18,000
$30,000
5
B
600
3,000
20
C
3,500
10,000
10
D
1,000
15,000
40
198
PART 2
LG3
Important Financial Concepts
4–18
Future value of an annuity For each case in the accompanying table, answer
the questions that follow.
Case
Amount of
annuity
A
$ 2,500
Interest
rate
Deposit period
(years)
8%
10
B
500
12
6
C
30,000
20
5
D
11,500
9
8
E
6,000
14
30
a. Calculate the future value of the annuity assuming that it is
(1) an ordinary annuity.
(2) an annuity due.
b. Compare your findings in parts a(1) and a(2). All else being identical, which
type of annuity—ordinary or annuity due—is preferable? Explain why.
LG3
4–19
Present value of an annuity Consider the following cases.
Case
Amount of annuity
Interest rate
A
$ 12,000
B
55,000
12
15
9
7%
Period (years)
3
C
700
20
D
140,000
5
7
E
22,500
10
5
a. Calculate the present value of the annuity assuming that it is
(1) an ordinary due.
(2) an annuity due.
b. Compare your findings in parts a(1) and a(2). All else being identical, which
type of annuity—ordinary or annuity due—is preferable? Explain why.
LG3
4–20
Ordinary annuity versus annuity due Marian Kirk wishes to select the better of
two 10-year annuities, C and D. Annuity C is an ordinary annuity of $2,500 per
year for 10 years. Annuity D is an annuity due of $2,200 per year for 10 years.
a. Find the future value of both annuities at the end of year 10, assuming that
Marian can earn (1) 10% annual interest and (2) 20% annual interest.
b. Use your findings in part a to indicate which annuity has the greater future
value at the end of year 10 for both the (1) 10% and (2) 20% interest rates.
c. Find the present value of both annuities, assuming that Marian can earn (1)
10% annual interest and (2) 20% annual interest.
d. Use your findings in part c to indicate which annuity has the greater present
value for both (1) 10% and (2) 20% interest rates.
e. Briefly compare, contrast, and explain any differences between your findings
using the 10% and 20% interest rates in parts b and d.
CHAPTER 4
Time Value of Money
199
LG3
4–21
Future value of a retirement annuity Hal Thomas, a 25-year-old college
graduate, wishes to retire at age 65. To supplement other sources of retirement
income, he can deposit $2,000 each year into a tax-deferred individual retirement arrangement (IRA). The IRA will be invested to earn an annual return of
10%, which is assumed to be attainable over the next 40 years.
a. If Hal makes annual end-of-year $2,000 deposits into the IRA, how much
will he have accumulated by the end of his 65th year?
b. If Hal decides to wait until age 35 to begin making annual end-of-year
$2,000 deposits into the IRA, how much will he have accumulated by the end
of his 65th year?
c. Using your findings in parts a and b, discuss the impact of delaying making
deposits into the IRA for 10 years (age 25 to age 35) on the amount accumulated by the end of Hal’s 65th year.
d. Rework parts a, b, and c, assuming that Hal makes all deposits at the
beginning, rather than the end, of each year. Discuss the effect of beginningof-year deposits on the future value accumulated by the end of Hal’s
65th year.
LG3
4–22
Present value of a retirement annuity An insurance agent is trying to sell you
an immediate-retirement annuity, which for a single amount paid today will provide you with $12,000 at the end of each year for the next 25 years. You currently earn 9% on low-risk investments comparable to the retirement annuity.
Ignoring taxes, what is the most you would pay for this annuity?
LG2
LG3
4–23
Funding your retirement You plan to retire in exactly 20 years. Your goal is to
create a fund that will allow you to receive $20,000 at the end of each year for
the 30 years between retirement and death (a psychic told you would die after
30 years). You know that you will be able to earn 11% per year during the 30year retirement period.
a. How large a fund will you need when you retire in 20 years to provide the
30-year, $20,000 retirement annuity?
b. How much will you need today as a single amount to provide the fund calculated in part a if you earn only 9% per year during the 20 years preceding
retirement?
c. What effect would an increase in the rate you can earn both during
and prior to retirement have on the values found in parts a and b?
Explain.
LG2
LG3
4–24
Present value of an annuity versus a single amount Assume that you just won
the state lottery. Your prize can be taken either in the form of $40,000 at the
end of each of the next 25 years (i.e., $1,000,000 over 25 years) or as a single
amount of $500,000 paid immediately.
a. If you expect to be able to earn 5% annually on your investments over the
next 25 years, ignoring taxes and other considerations, which alternative
should you take? Why?
b. Would your decision in part a change if you could earn 7% rather than 5%
on your investments over the next 25 years? Why?
c. On a strictly economic basis, at approximately what earnings rate would you
be indifferent between the two plans?
200
PART 2
LG3
Important Financial Concepts
4–25
Perpetuities
Consider the data in the following table.
Perpetuity
Annual amount
Discount rate
A
$ 20,000
8%
B
100,000
10
C
3,000
6
D
60,000
5
Determine, for each of the perpetuities:
a. The appropriate present value interest factor.
b. The present value.
LG3
4–26
Creating an endowment Upon completion of her introductory finance course,
Marla Lee was so pleased with the amount of useful and interesting knowledge
she gained that she convinced her parents, who were wealthy alums of the
university she was attending, to create an endowment. The endowment is to
allow three needy students to take the introductory finance course each year in
perpetuity. The guaranteed annual cost of tuition and books for the course is
$600 per student. The endowment will be created by making a single payment
to the university. The university expects to earn exactly 6% per year on these
funds.
a. How large an initial single payment must Marla’s parents make to the university to fund the endowment?
b. What amount would be needed to fund the endowment if the university
could earn 9% rather than 6% per year on the funds?
LG4
4–27
Future value of a mixed stream For each of the mixed streams of cash flows
shown in the following table, determine the future value at the end of the final
year if deposits are made into an account paying annual interest of 12%, assuming that no withdrawals are made during the period and that the deposits
are made:
a. At the end of each year.
b. At the beginning of each year.
Cash flow stream
LG4
4–28
Year
A
B
C
1
$ 900
$30,000
$1,200
2
1,000
25,000
1,200
3
1,200
20,000
1,000
4
10,000
1,900
5
5,000
Future value of a single amount versus a mixed stream Gina Vitale has just
contracted to sell a small parcel of land that she inherited a few years ago. The
buyer is willing to pay $24,000 at the closing of the transaction or will pay the
amounts shown in the following table at the beginning of each of the next
CHAPTER 4
Time Value of Money
201
5 years. Because Gina doesn’t really need the money today, she plans to let it
accumulate in an account that earns 7% annual interest. Given her desire to buy
a house at the end of 5 years after closing on the sale of the lot, she decides to
choose the payment alternative—$24,000 single amount or the mixed stream of
payments in the following table—that provides the higher future value at the end
of 5 years. Which alternative will she choose?
Mixed stream
Beginning of year
LG4
4–29
1
$ 2,000
2
4,000
3
6,000
4
8,000
5
10,000
Present value—Mixed streams Find the present value of the streams of cash
flows shown in the following table. Assume that the firm’s opportunity cost
is 12%.
A
LG4
4–30
Cash flow
B
Year
Cash flow
Year
1
$2,000
2
3,000
2–5
3
4,000
6
4
6,000
5
8,000
1
C
Cash flow
Year
Cash flow
$10,000
1–5
$10,000/yr
5,000/yr
6–10
8,000/yr
7,000
Present value—Mixed streams Consider the mixed streams of cash flows
shown in the following table.
Cash flow stream
Year
A
B
1
$ 50,000
$ 10,000
2
40,000
20,000
3
30,000
30,000
4
20,000
40,000
5
10,000
$150,000
50,000
$150,000
Totals
a. Find the present value of each stream using a 15% discount rate.
b. Compare the calculated present values and discuss them in light of the fact
that the undiscounted cash flows total $150,000 in each case.
202
PART 2
LG1
Important Financial Concepts
LG4
4–31
Present value of a mixed stream Harte Systems, Inc., a maker of electronic surveillance equipment, is considering selling to a well-known hardware chain the
rights to market its home security system. The proposed deal calls for payments
of $30,000 and $25,000 at the end of years 1 and 2 and for annual year-end
payments of $15,000 in years 3 through 9. A final payment of $10,000 would
be due at the end of year 10.
a. Lay out the cash flows involved in the offer on a time line.
b. If Harte applies a required rate of return of 12% to them, what is the present
value of this series of payments?
c. A second company has offered Harte a one-time payment of $100,000 for
the rights to market the home security system. Which offer should Harte
accept?
LG4
4–32
Funding budget shortfalls As part of your personal budgeting process, you
have determined that in each of the next 5 years you will have budget shortfalls.
In other words, you will need the amounts shown in the following table at the
end of the given year to balance your budget—that is, to make inflows equal
outflows. You expect to be able to earn 8% on your investments during the next
5 years and wish to fund the budget shortfalls over the next 5 years with a single
amount.
End of year
Budget shortfall
1
$ 5,000
2
4,000
3
6,000
4
10,000
5
3,000
a. How large must the single deposit today into an account paying 8% annual
interest be to provide for full coverage of the anticipated budget shortfalls?
b. What effect would an increase in your earnings rate have on the amount calculated in part a? Explain.
LG4
4–33
Relationship between future value and present value—Mixed stream Using
only the information in the accompanying table, answer the questions that follow.
Year (t)
Cash flow
Future value interest factor
at 5% (FVIF5%,t)
1
$ 800
1.050
2
900
1.102
3
1,000
1.158
4
1,500
1.216
5
2,000
1.276
CHAPTER 4
Time Value of Money
203
a. Determine the present value of the mixed stream of cash flows using a 5%
discount rate.
b. How much would you be willing to pay for an opportunity to buy this
stream, assuming that you can at best earn 5% on your investments?
c. What effect, if any, would a 7% rather than a 5% opportunity cost have on
your analysis? (Explain verbally.)
LG5
4–34
Changing compounding frequency Using annual, semiannual, and quarterly
compounding periods, for each of the following: (1) Calculate the future
value if $5,000 is initially deposited, and (2) determine the effective annual
rate (EAR).
a. At 12% annual interest for 5 years.
b. At 16% annual interest for 6 years.
c. At 20% annual interest for 10 years.
LG5
4–35
Compounding frequency, future value, and effective annual rates For each of
the cases in the following table:
a. Calculate the future value at the end of the specified deposit period.
b. Determine the effective annual rate, EAR.
c. Compare the nominal annual rate, i, to the effective annual rate, EAR. What
relationship exists between compounding frequency and the nominal and
effective annual rates.
LG5
LG5
4–36
4–37
Case
Amount of
initial deposit
A
$ 2,500
B
50,000
Compounding
frequency, m
(times/year)
Nominal
annual rate, i
6%
12
Deposit period
(years)
2
5
6
3
C
1,000
5
1
10
D
20,000
16
4
6
Continuous compounding For each of the cases in the following table, find the
future value at the end of the deposit period, assuming that interest is compounded continuously at the given nominal annual rate.
Case
Amount of
initial deposit
Nominal
annual rate, i
A
$1,000
B
600
10
10
C
4,000
8
7
D
2,500
12
4
9%
Deposit
period (years), n
2
Compounding frequency and future value You plan to invest $2,000 in an
individual retirement arrangement (IRA) today at a nominal annual rate of 8%,
which is expected to apply to all future years.
204
PART 2
Important Financial Concepts
a. How much will you have in the account at the end of 10 years if interest is
compounded (1) annually? (2) semiannually? (3) daily (assume a 360-day
year)? (4) continuously?
b. What is the effective annual rate, EAR, for each compounding period in
part a?
c. How much greater will your IRA account balance be at the end of 10 years if
interest is compounded continuously rather than annually?
d. How does the compounding frequency affect the future value and effective
annual rate for a given deposit? Explain in terms of your findings in parts a
through c.
LG3
LG5
4–38
Comparing compounding periods René Levin wishes to determine the future
value at the end of 2 years of a $15,000 deposit made today into an account
paying a nominal annual rate of 12%.
a. Find the future value of René’s deposit, assuming that interest is compounded
(1) annually, (2) quarterly, (3) monthly, and (4) continuously.
b. Compare your findings in part a, and use them to demonstrate the relationship between compounding frequency and future value.
c. What is the maximum future value obtainable given the $15,000 deposit, the
2-year time period, and the 12% nominal annual rate? Use your findings in
part a to explain.
LG5
4–39
Annuities and compounding Janet Boyle intends to deposit $300 per year in a
credit union for the next 10 years, and the credit union pays an annual interest
rate of 8%.
a. Determine the future value that Janet will have at the end of 10 years, given
that end-of-period deposits are made and no interest is withdrawn, if
(1) $300 is deposited annually and the credit union pays interest annually.
(2) $150 is deposited semiannually and the credit union pays interest semiannually.
(3) $75 is deposited quarterly and the credit union pays interest quarterly.
b. Use your finding in part a to discuss the effect of more frequent deposits and
compounding of interest on the future value of an annuity.
LG6
4–40
Deposits to accumulate future sums For each of the cases shown in the following table, determine the amount of the equal annual end-of-year deposits necessary to accumulate the given sum at the end of the specified period, assuming the
stated annual interest rate.
LG6
4–41
Case
Sum to be
accumulated
Accumulation
period (years)
Interest rate
A
B
$ 5,000
3
12%
100,000
20
7
C
D
30,000
8
10
15,000
12
8
Creating a retirement fund To supplement your planned retirement in exactly
42 years, you estimate that you need to accumulate $220,000 by the end of
CHAPTER 4
Time Value of Money
205
42 years from today. You plan to make equal annual end-of-year deposits into
an account paying 8% annual interest.
a. How large must the annual deposits be to create the $220,000 fund by the
end of 42 years?
b. If you can afford to deposit only $600 per year into the account, how much
will you have accumulated by the end of the 42nd year?
LG2
LG6
4–42
Accumulating a growing future sum A retirement home at Deer Trail Estates
now costs $85,000. Inflation is expected to cause this price to increase at 6%
per year over the 20 years before C. L. Donovan retires. How large an equal
annual end-of-year deposit must be made each year into an account paying an
annual interest rate of 10% for Donovan to have the cash to purchase a home at
retirement?
LG3
LG6
4–43
Deposits to create a perpetuity You have decided to endow your favorite university with a scholarship. It is expected to cost $6,000 per year to attend the
university into perpetuity. You expect to give the university the endowment in
10 years and will accumulate it by making annual (end-of-year) deposits into an
account. The rate of interest is expected to be 10% for all future time periods.
a. How large must the endowment be?
b. How much must you deposit at the end of each of the next 10 years to accumulate the required amount?
LG3
LG6
4–44
Inflation, future value, and annual deposits While vacationing in Florida, John
Kelley saw the vacation home of his dreams. It was listed with a sale price of
$200,000. The only catch is that John is 40 years old and plans to continue
working until he is 65. Still, he believes that prices generally increase at the overall rate of inflation. John believes that he can earn 9% annually after taxes on
his investments. He is willing to invest a fixed amount at the end of each of the
next 25 years to fund the cash purchase of such a house (one that can be purchased today for $200,000) when he retires.
a. Inflation is expected to average 5% a year for the next 25 years. What will
John’s dream house cost when he retires?
b. How much must John invest at the end of each of the next 25 years in order
to have the cash purchase price of the house when he retires?
c. If John invests at the beginning instead of at the end of each of the next 25
years, how much must he invest each year?
LG6
4–45
Loan payment Determine the equal annual end-of-year payment required each
year, over the life of the loans shown in the following table, to repay them fully
during the stated term of the loan.
Loan
Principal
Interest rate
A
$12,000
B
60,000
12
10
C
75,000
10
30
D
4,000
15
5
8%
Term of loan (years)
3
206
PART 2
Important Financial Concepts
LG6
4–46
Loan amortization schedule Joan Messineo borrowed $15,000 at a 14%
annual rate of interest to be repaid over 3 years. The loan is amortized into three
equal annual end-of-year payments.
a. Calculate the annual end-of-year loan payment.
b. Prepare a loan amortization schedule showing the interest and principal
breakdown of each of the three loan payments.
c. Explain why the interest portion of each payment declines with the passage
of time.
LG6
4–47
Loan interest deductions Liz Rogers just closed a $10,000 business loan that is
to be repaid in three equal annual end-of-year payments. The interest rate on the
loan is 13%. As part of her firm’s detailed financial planning, Liz wishes to
determine the annual interest deduction attributable to the loan. (Because it is a
business loan, the interest portion of each loan payment is tax-deductible to the
business.)
a. Determine the firm’s annual loan payment.
b. Prepare an amortization schedule for the loan.
c. How much interest expense will Liz’s firm have in each of the next 3 years as
a result of this loan?
LG6
4–48
Monthly loan payments Tim Smith is shopping for a used car. He has found
one priced at $4,500. The dealer has told Tim that if he can come up with a
down payment of $500, the dealer will finance the balance of the price at a 12%
annual rate over 2 years (24 months).
a. Assuming that Tim accepts the dealer’s offer, what will his monthly (end-ofmonth) payment amount be?
b. Use a financial calculator or Equation 4.15a (found in footnote 9) to help
you figure out what Tim’s monthly payment would be if the dealer were
willing to finance the balance of the car price at a 9% yearly rate.
LG6
4–49
Growth rates You are given the series of cash flows shown in the following
table.
Cash flows
Year
A
B
C
1
$500
$1,500
$2,500
2
560
1,550
2,600
3
640
1,610
2,650
4
720
1,680
2,650
5
800
1,760
2,800
6
1,850
2,850
7
1,950
2,900
8
2,060
9
2,170
10
2,280
a. Calculate the compound annual growth rate associated with each cash flow
stream.
CHAPTER 4
Time Value of Money
207
b. If year-1 values represent initial deposits in a savings account paying annual
interest, what is the annual rate of interest earned on each account?
c. Compare and discuss the growth rate and interest rate found in parts a and b,
respectively.
LG6
4–50
Rate of return Rishi Singh has $1,500 to invest. His investment counselor suggests an investment that pays no stated interest but will return $2,000 at the end
of 3 years.
a. What annual rate of return will Mr. Singh earn with this investment?
b. Mr. Singh is considering another investment, of equal risk, that earns an
annual return of 8%. Which investment should he make, and why?
LG6
4–51
Rate of return and investment choice Clare Jaccard has $5,000 to invest.
Because she is only 25 years old, she is not concerned about the length of the
investment’s life. What she is sensitive to is the rate of return she will earn on the
investment. With the help of her financial advisor, Clare has isolated the four
equally risky investments, each providing a single amount at the end of its life, as
shown in the following table. All of the investments require an initial $5,000
payment.
Investment
Single amount
Investment life (years)
A
$ 8,400
6
B
15,900
15
C
7,600
4
D
13,000
10
a. Calculate, to the nearest 1%, the rate of return on each of the four investments available to Clare.
b. Which investment would you recommend to Clare, given her goal of maximizing the rate of return?
LG6
4–52
Rate of return—Annuity What is the rate of return on an investment of $10,606
if the company will receive $2,000 each year for the next 10 years?
LG6
4–53
Choosing the best annuity Raina Herzig wishes to choose the best of four
immediate-retirement annuities available to her. In each case, in exchange for
paying a single premium today, she will receive equal annual end-of-year cash
benefits for a specified number of years. She considers the annuities to be equally
risky and is not concerned about their differing lives. Her decision will be based
solely on the rate of return she will earn on each annuity. The key terms of each
of the four annuities are shown in the following table.
Annuity
Premium paid today
Annual benefit
Life (years)
A
$30,000
$3,100
20
B
25,000
3,900
10
C
40,000
4,200
15
D
35,000
4,000
12
208
PART 2
Important Financial Concepts
a. Calculate to the nearest 1% the rate of return on each of the four annuities
Raina is considering.
b. Given Raina’s stated decision criterion, which annuity would you
recommend?
LG6
4–54
Interest rate for an annuity Anna Waldheim was seriously injured in an industrial accident. She sued the responsible parties and was awarded a judgment of
$2,000,000. Today, she and her attorney are attending a settlement conference
with the defendants. The defendants have made an initial offer of $156,000 per
year for 25 years. Anna plans to counteroffer at $255,000 per year for 25 years.
Both the offer and the counteroffer have a present value of $2,000,000, the
amount of the judgment. Both assume payments at the end of each year.
a. What interest rate assumption have the defendants used in their offer
(rounded to the nearest whole percent)?
b. What interest rate assumption have Anna and her lawyer used in their counteroffer (rounded to the nearest whole percent)?
c. Anna is willing to settle for an annuity that carries an interest rate assumption of 9%. What annual payment would be acceptable to her?
LG6
4–55
Loan rates of interest John Flemming has been shopping for a loan to finance
the purchase of a used car. He has found three possibilities that seem attractive
and wishes to select the one with the lowest interest rate. The information
available with respect to each of the three $5,000 loans is shown in the following table.
Loan
Principal
Annual payment
Term (years)
A
$5,000
$1,352.81
5
B
5,000
1,543.21
4
C
5,000
2,010.45
3
a. Determine the interest rate associated with each of the loans.
b. Which loan should Mr. Flemming take?
LG6
4–56
Number of years—Single amounts For each of the following cases, determine
the number of years it will take for the initial deposit to grow to equal the future
amount at the given interest rate.
Case
A
Initial deposit
$
Future amount
Interest rate
7%
300
$ 1,000
B
12,000
15,000
5
C
9,000
20,000
10
D
100
500
9
E
7,500
30,000
15
CHAPTER 4
Time Value of Money
209
LG6
4–57
Time to accumulate a given sum Manuel Rios wishes to determine how long it
will take an initial deposit of $10,000 to double.
a. If Manuel earns 10% annual interest on the deposit, how long will it take for
him to double his money?
b. How long will it take if he earns only 7% annual interest?
c. How long will it take if he can earn 12% annual interest?
d. Reviewing your findings in parts a, b, and c, indicate what relationship exists
between the interest rate and the amount of time it will take Manuel to double his money?
LG6
4–58
Number of years—Annuities In each of the following cases, determine the
number of years that the given annual end-of-year cash flow must continue in
order to provide the given rate of return on the given initial amount.
LG6
4–59
CHAPTER 4 CASE
Case
Initial amount
Annual cash flow
A
$ 1,000
B
150,000
30,000
15
C
80,000
10,000
10
D
600
275
9
E
17,000
3,500
6
$
250
Rate of return
11%
Time to repay installment loan Mia Salto wishes to determine how long it will
take to repay a loan with initial proceeds of $14,000 where annual end-of-year
installment payments of $2,450 are required.
a. If Mia can borrow at a 12% annual rate of interest, how long will it take for
her to repay the loan fully?
b. How long will it take if she can borrow at a 9% annual rate?
c. How long will it take if she has to pay 15% annual interest?
d. Reviewing your answers in parts a, b, and c, describe the general relationship
between the interest rate and the amount of time it will take Mia to repay the
loan fully.
Finding Jill Moran’s Retirement Annuity
S
unrise Industries wishes to accumulate funds to provide a retirement annuity
for its vice president of research, Jill Moran. Ms. Moran by contract will
retire at the end of exactly 12 years. Upon retirement, she is entitled to receive an
annual end-of-year payment of $42,000 for exactly 20 years. If she dies prior to
the end of the 20-year period, the annual payments will pass to her heirs. During
the 12-year “accumulation period” Sunrise wishes to fund the annuity by making equal annual end-of-year deposits into an account earning 9% interest. Once
the 20-year “distribution period” begins, Sunrise plans to move the accumulated
monies into an account earning a guaranteed 12% per year. At the end of the
distribution period, the account balance will equal zero. Note that the first
210
PART 2
Important Financial Concepts
deposit will be made at the end of year 1 and that the first distribution payment
will be received at the end of year 13.
Required
a. Draw a time line depicting all of the cash flows associated with Sunrise’s view
of the retirement annuity.
b. How large a sum must Sunrise accumulate by the end of year 12 to provide
the 20-year, $42,000 annuity?
c. How large must Sunrise’s equal annual end-of-year deposits into the account
be over the 12-year accumulation period to fund fully Ms. Moran’s retirement annuity?
d. How much would Sunrise have to deposit annually during the accumulation period if it could earn 10% rather than 9% during the accumulation
period?
e. How much would Sunrise have to deposit annually during the accumulation
period if Ms. Moran’s retirement annuity were a perpetuity and all other
terms were the same as initially described?
WEB EXERCISE
WW
W
Go to Web site www.arachnoid.com/lutusp/finance_old.html. Page down to the
portion of this screen that contains the financial calculator.
1. To determine the FV of a fixed amount, enter the following:
Into PV, enter 1000; into np, enter 1; into pmt, enter 0; and, into ir,
enter 8.
Now click on Calculate FV, and 1080.00 should appear in the FV window.
2. Determine FV for each of the following compounding periods by changing
only the following:
a. np to 2, and ir to 8/2
b. np to 12, and ir to 8/12
c. np to 52, and ir to 8/52
3. To determine the PV of a fixed amount, enter the following:
Into FV, 1080; into np, 1; into pmt, 0; and, into ir, 8. Now click on
Calculate PV. What is the PV?
4. To determine the FV of an annuity, enter the following:
Into PV, 0; into FV, 0; into np, 12; into pmt, 1000; and, into ir, 8. Now
click on Calculate FV. What is the FV?
5. To determine the PV of an annuity, change only the FV setting to 0; keep
the other entries the same as in question 4. Click on Calculate PV. What is
the PV?
6. Check your answers for questions 4 and 5 by using the techniques discussed
in this chapter.
CHAPTER 4
Time Value of Money
211
Go to Web site www.homeowners.com/. Click on Calculators in the left column.
Click on Mortgage Calculator.
7. Enter the following into the mortgage calculator: Loan amount, 100000;
duration in years, 30; and interest rate, 10. Click on compute payment.
What is the monthly payment?
8. Calculate the monthly payment for $100,000 loans for 30 years at 8%, 6%,
4%, and 2%.
9. Calculate the monthly payment for $100,000 loans at 8% for 30 years,
20 years, 10 years, and 5 years.
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
CHAPTER
5
RISK
AND RETURN
L E A R N I N G
LG1
Understand the meaning and fundamentals of risk,
return, and risk preferences.
LG2
Describe procedures for assessing and measuring the risk of a single asset.
LG3
LG4
Discuss the measurement of return and standard
deviation for a portfolio and the various types
of correlation that can exist between series of
numbers.
LG5
LG6
G O A L S
Review the two types of risk and the derivation
and role of beta in measuring the relevant risk of
both an individual security and a portfolio.
Explain the capital asset pricing model (CAPM),
its relationship to the security market line (SML),
and shifts in the SML caused by changes in inflationary expectations and risk aversion.
Understand the risk and return characteristics of
a portfolio in terms of correlation and diversification, and the impact of international assets on a
portfolio.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand the relationship between
risk and return because of the effect that riskier projects will
have on the firm’s annual net income and on your efforts to
stabilize net income.
Information systems: You need to understand how to do sensitivity and correlation analyses in order to build decision packages that help management analyze the risk and return of various business opportunities.
Management: You need to understand the relationship
between risk and return, and how to measure that relationship
in order to evaluate data that come from finance personnel and
212
translate those data into decisions that increase the value of
the firm.
Marketing: You need to understand that although higher-risk
projects may produce higher returns, they may not be the best
choice for the firm if they produce an erratic earnings pattern
and do not optimize the value of the firm.
Operations: You need to understand how investments in plant
assets and purchases of supplies will be measured by the firm
and to recognize that decisions about such investments will be
made by evaluating the effects of both risk and return on the
value of the firm.
CITIGROUP
CITIGROUP TAKES ON
NEW ASSOCIATES
s they chased after hot new financial
services businesses that boosted
earnings quickly, many banks ignored a
key principle of risk management: Diversification reduces risk. They expanded
into risky areas such as investment
banking, stock brokerage, wealth management, and equity investment, and they moved away
from their traditional services such as mortgage banking, auto financing, and credit cards.
Although adding new business lines is a way to diversify, the benefits of diversification come from
balancing low-risk and high-risk activities. As the economy changed, banks ran into problems
with these new, higher-risk services. Banks that had “hedged their bets” by continuing to offer a
variety of services spread across the risk spectrum earned higher returns.
Citigroup is a case study for the benefits of diversification. The company, created in 1998 by
the merger of Citicorp and Travelers Group, provides a broad range of financial products and services to 100 million consumers, corporations, governments, and institutions in over 100 countries.
These offerings include consumer banking and credit, corporate and investment banking, commercial finance, leasing, insurance, securities brokerage, and asset management. Under the
leadership of Citigroup CEO Sandy Weill, the company made acquisitions that reduced its dependence on corporate and investment banking. In September 2000, Citigroup bought Associates
First Capital Corp for $31 billion.
With the acquisition of Associates, Citigroup shifted the balance of its business more toward
consumers than toward institutions. Associates’s target market is the lower-middle economic
class. Although these customers are riskier than the traditional bank customer, the rewards are
greater too, because Associates can charge higher interest rates and fees to compensate itself
for taking on the additional risk. The existing consumer finance businesses of both Associates and
Citigroup know how to handle this type of lending and earn solid returns in the process.
A more diversified group of businesses with greater emphasis on the consumer side should
reduce Citigroup’s earnings volatility and improve shareholder value. Commenting in spring 2001
on the corporation’s ability to weather the current economic downturn, Weill said, “The strength
and diversity of our earnings by business, geography, and customer helped to deliver a strong
bottom line in a period of market uncertainty.” Citigroup’s return on equity (ROE) for the first quarter 2001 was 22.5 percent, just above fiscal year 2000’s 22.4 percent and better than its average
ROE of 19 percent for the period 1998 to 2000.
Citigroup and its consumer business units demonstrate several key fundamental financial
concepts: Risk and return are linked, return should increase if risk increases, and diversification
reduces risk. As this chapter will show, firms can use various tools and techniques to quantify
and assess the risk and return for individual assets and for groups of assets.
A
213
214
PART 2
Important Financial Concepts
LG1
5.1 Risk and Return Fundamentals
portfolio
A collection, or group, of assets.
To maximize share price, the financial manager must learn to assess two key
determinants: risk and return.1 Each financial decision presents certain risk and
return characteristics, and the unique combination of these characteristics has an
impact on share price. Risk can be viewed as it is related either to a single asset or
to a portfolio—a collection, or group, of assets. We will look at both, beginning
with the risk of a single asset. First, though, it is important to introduce some fundamental ideas about risk, return, and risk preferences.
Risk Defined
risk
The chance of financial loss or,
more formally, the variability of
returns associated with a given
asset.
In the most basic sense, risk is the chance of financial loss. Assets having greater
chances of loss are viewed as more risky than those with lesser chances of loss.
More formally, the term risk is used interchangeably with uncertainty to refer to
the variability of returns associated with a given asset. A $1,000 government
bond that guarantees its holder $100 interest after 30 days has no risk, because
there is no variability associated with the return. A $1,000 investment in a firm’s
common stock, which over the same period may earn anywhere from $0 to $200,
is very risky because of the high variability of its return. The more nearly certain
the return from an asset, the less variability and therefore the less risk.
Some risks directly affect both financial managers and shareholders. Table 5.1
briefly describes the common sources of risk that affect both firms and their shareholders. As you can see, business risk and financial risk are more firm-specific and
therefore are of greatest interest to financial managers. Interest rate, liquidity, and
market risks are more shareholder-specific and therefore are of greatest interest to
stockholders. Event, exchange rate, purchasing-power, and tax risk directly affect
both firms and shareholders. The nearby box focuses on another risk that affects
both firms and shareholders—moral risk. A number of these risks are discussed in
more detail later in this text. Clearly, both financial managers and shareholders
must assess these and other risks as they make investment decisions.
Return Defined
return
The total gain or loss experienced on an investment over a
given period of time; calculated
by dividing the asset’s cash
distributions during the period,
plus change in value, by its
beginning-of-period investment
value.
Obviously, if we are going to assess risk on the basis of variability of return, we
need to be certain we know what return is and how to measure it. The return is
the total gain or loss experienced on an investment over a given period of time. It
is commonly measured as cash distributions during the period plus the change in
value, expressed as a percentage of the beginning-of-period investment value. The
expression for calculating the rate of return earned on any asset over period t, kt,
is commonly defined as
Ct Pt Pt1
kt Pt1
(5.1)
1. Two important points should be recognized here: (1) Although for convenience the publicly traded corporation is
being discussed, the risk and return concepts presented apply to all firms; and (2) concern centers only on the wealth
of common stockholders, because they are the “residual owners” whose returns are in no way specified in advance.
CHAPTER 5
TABLE 5.1
Risk and Return
215
Popular Sources of Risk Affecting Financial Managers
and Shareholders
Source of risk
Description
Firm-Specific Risks
Business risk
The chance that the firm will be unable to cover its operating costs. Level is driven by the firm’s
revenue stability and the structure of its operating costs (fixed vs. variable).
Financial risk
The chance that the firm will be unable to cover its financial obligations. Level is driven by the
predictability of the firm’s operating cash flows and its fixed-cost financial obligations.
Shareholder-Specific Risks
Interest rate risk
The chance that changes in interest rates will adversely affect the value of an investment. Most
investments lose value when the interest rate rises and increase in value when it falls.
Liquidity risk
The chance that an investment cannot be easily liquidated at a reasonable price. Liquidity is significantly affected by the size and depth of the market in which an investment is customarily traded.
Market risk
The chance that the value of an investment will decline because of market factors that are independent of the investment (such as economic, political, and social events). In general, the more a
given investment’s value responds to the market, the greater its risk; and the less it responds, the
smaller its risk.
Firm and Shareholder Risks
Event risk
The chance that a totally unexpected event will have a significant effect on the value of the firm
or a specific investment. These infrequent events, such as government-mandated withdrawal of a
popular prescription drug, typically affect only a small group of firms or investments.
Exchange rate risk
The exposure of future expected cash flows to fluctuations in the currency exchange rate. The
greater the chance of undesirable exchange rate fluctuations, the greater the risk of the cash flows
and therefore the lower the value of the firm or investment.
Purchasing-power risk
The chance that changing price levels caused by inflation or deflation in the economy will
adversely affect the firm’s or investment’s cash flows and value. Typically, firms or investments
with cash flows that move with general price levels have a low purchasing-power risk, and those
with cash flows that do not move with general price levels have high purchasing-power risk.
Tax risk
The chance that unfavorable changes in tax laws will occur. Firms and investments with values
that are sensitive to tax law changes are more risky.
where
kt actual,expected, or required rate of return2 during period t
Ct cash (flow) received from the asset investment in the time period
t 1 to t
Pt price (value) of asset at time t
Pt1 price (value) of asset at time t 1
2. The terms expected return and required return are used interchangeably throughout this text, because in an efficient market (discussed later) they would be expected to be equal. The actual return is an ex post value, whereas
expected and required returns are ex ante values. Therefore, the actual return may be greater than, equal to, or less
than the expected/required return.
216
PART 2
Important Financial Concepts
FOCUS ON ETHICS
In Practice
What About Moral Risk?
The poster boy for “moral risk,”
the devastating effects of unethical behavior for a company’s
investors, has to be Nick Leeson.
This 28-year-old trader violated
his bank’s investing rules while
secretly placing huge bets on the
direction of the Japanese stock
market. When those bets proved
to be wrong, the $1.24-billion
losses resulted in the demise of
the centuries-old Barings Bank.
More than any other single
episode in world financial history,
Leeson’s misdeeds underscored
the importance of character in
the financial industry. Forty-one
percent of surveyed CFOs admit
ethical problems in their organizations (self-reported percents are
probably low), and 48 percent of
surveyed employees admit to
engaging in unethical practices
such as cheating on expense
accounts and forging signatures.
We are reminded again that share-
holder wealth maximization has to
be ethically constrained.
What can companies do to
instill and maintain ethical corporate practices? They can start by
building awareness through a
code of ethics. Nearly all Fortune
500 companies and about half of
all companies have an ethics code
spelling out general principles of
right and wrong conduct. Companies such as Halliburton and
Texas Instruments have gone into
specifics, because ethical codes
are often faulted for being too
vague and abstract.
Ethical organizations also
reveal their commitments through
the following activities: talking
about ethical values periodically;
including ethics in required training for mid-level managers (as at
Procter & Gamble); modeling
ethics throughout top management
and the board (termed “tone at the
top,” especially notable at Johnson
& Johnson); promoting openness
for employees with concerns;
weeding out employees who do
not share the company’s ethics
values before those employees
can harm the company’s reputation or culture; assigning an individual the role of ethics director;
and evaluating leaders’ ethics
in performance reviews (as at
Merck & Co.).
The Leeson saga underscores the difficulty of dealing
with the “moral hazard” problem,
when the consequences of an
individual’s actions are largely
borne by others. John Boatright
argues in his book Ethics in
Finance that the best antidote is to
attract loyal, hardworking employees. Ethicists Rae and Wong tell
us that debating issues is fruitless
if we continue to ignore the character traits that empower people
for moral behavior.
The return, kt, reflects the combined effect of cash flow, Ct, and changes in value,
Pt Pt1, over period t.3
Equation 5.1 is used to determine the rate of return over a time period as
short as 1 day or as long as 10 years or more. However, in most cases, t is 1 year,
and k therefore represents an annual rate of return.
EXAMPLE
Robin’s Gameroom, a high-traffic video arcade, wishes to determine the return on
two of its video machines, Conqueror and Demolition. Conqueror was purchased
1 year ago for $20,000 and currently has a market value of $21,500. During the
year, it generated $800 of after-tax cash receipts. Demolition was purchased
4 years ago; its value in the year just completed declined from $12,000 to
$11,800. During the year, it generated $1,700 of after-tax cash receipts. Substi-
3. The beginning-of-period value, Pt1, and the end-of-period value, Pt, are not necessarily realized values. They are
often unrealized, which means that although the asset was not actually purchased at time t 1 and sold at time t,
values Pt1 and Pt could have been realized had those transactions been made.
CHAPTER 5
Risk and Return
217
tuting into Equation 5.1, we can calculate the annual rate of return, k, for each
video machine.
Conqueror (C):
$800 $21,500 $20,000
$2,300
kC 11.5%
$20,000
$20,000 Demolition (D):
$1,500
$1,700 $11,800 $12,000
kD 12.5%
$12,000
$12,000 Although the market value of Demolition declined during the year, its cash flow
caused it to earn a higher rate of return than Conqueror earned during the same
period. Clearly, the combined impact of cash flow and changes in value, measured by the rate of return, is important.
Historical Returns
Investment returns vary both over time and between different types of investments. By averaging historical returns over a long period of time, it is possible to
eliminate the impact of market and other types of risk. This enables the financial
decision maker to focus on the differences in return that are attributable primarily to the types of investment. Table 5.2 shows the average annual rates of return
for a number of popular security investments (and inflation) over the 75-year
period January 1, 1926, through December 31, 2000. Each rate represents the
average annual rate of return an investor would have realized had he or she purchased the investment on January 1, 1926, and sold it on December 31, 2000.
You can see that significant differences exist between the average annual rates of
return realized on the various types of stocks, bonds, and bills shown. Later in
this chapter, we will see how these differences in return can be linked to differences in the risk of each of these investments.
TABLE 5.2
Historical Returns for
Selected Security
Investments (1926–2000)
Investment
Average annual return
Large-company stocks
13.0%
Small-company stocks
17.3
Long-term corporate bonds
6.0
Long-term government bonds
5.7
U.S. Treasury bills
3.9
Inflation
3.2%
Source: Stocks, Bonds, Bills, and Inflation, 2001 Yearbook
(Chicago: Ibbotson Associates, Inc., 2001).
218
PART 2
Important Financial Concepts
Required (or Expected) Return
FIGURE 5.1
Risk Preferences
Risk preference behaviors
Risk-Averse
Averse
Indifferent
Risk-Indifferent
Seeking
Risk-Seeking
0
x1
x2
Risk
Risk Preferences
risk-indifferent
The attitude toward risk in which
no change in return would be
required for an increase in risk.
risk-averse
The attitude toward risk in which
an increased return would be
required for an increase in risk.
risk-seeking
The attitude toward risk in which
a decreased return would be
accepted for an increase in risk.
Hint Remember that
most shareholders are also
risk-averse. Like risk-averse
managers, for a given increase
in risk, they also require an
increase in return on their
investment in that firm.
Feelings about risk differ among managers (and firms).4 Thus it is important to
specify a generally acceptable level of risk. The three basic risk preference behaviors—risk-averse, risk-indifferent, and risk-seeking—are depicted graphically in
Figure 5.1.
• For the risk-indifferent manager, the required return does not change as risk
goes from x1 to x2. In essence, no change in return would be required for the
increase in risk. Clearly, this attitude is nonsensical in almost any business
context.
• For the risk-averse manager, the required return increases for an increase in
risk. Because they shy away from risk, these managers require higher
expected returns to compensate them for taking greater risk.
• For the risk-seeking manager, the required return decreases for an increase in
risk. Theoretically, because they enjoy risk, these managers are willing to give
up some return to take more risk. However, such behavior would not be
likely to benefit the firm.
Most managers are risk-averse; for a given increase in risk, they require an
increase in return. They generally tend to be conservative rather than aggressive
when accepting risk for their firm. Accordingly, a risk-averse financial manager
requiring higher returns for greater risk is assumed throughout this text.
Review Questions
5–1
5–2
What is risk in the context of financial decision making?
Define return, and describe how to find the rate of return on an investment.
4. The risk preferences of the managers should in theory be consistent with the risk preferences of the firm. Although
the agency problem suggests that in practice managers may not behave in a manner consistent with the firm’s risk
preferences, it is assumed here that they do. Therefore, the managers’ risk preferences and those of the firm are
assumed to be identical.
CHAPTER 5
5–3
LG2
Risk and Return
219
Compare the following risk preferences: (a) risk-averse, (b) risk-indifferent,
and (c) risk-seeking. Which is most common among financial managers?
5.2 Risk of a Single Asset
The concept of risk can be developed by first considering a single asset held in
isolation. We can look at expected-return behaviors to assess risk, and statistics
can be used to measure it.
Risk Assessment
Sensitivity analysis and probability distributions can be used to assess the general
level of risk embodied in a given asset.
sensitivity analysis
An approach for assessing risk
that uses several possible-return
estimates to obtain a sense of the
variability among outcomes.
range
A measure of an asset’s risk,
which is found by subtracting the
pessimistic (worst) outcome from
the optimistic (best) outcome.
EXAMPLE
Sensitivity Analysis
Sensitivity analysis uses several possible-return estimates to obtain a sense of the
variability among outcomes.5 One common method involves making pessimistic
(worst), most likely (expected), and optimistic (best) estimates of the returns
associated with a given asset. In this case, the asset’s risk can be measured by the
range of returns. The range is found by subtracting the pessimistic outcome from
the optimistic outcome. The greater the range, the more variability, or risk, the
asset is said to have.
Norman Company, a custom golf equipment manufacturer, wants to choose the
better of two investments, A and B. Each requires an initial outlay of $10,000,
and each has a most likely annual rate of return of 15%. Management has made
pessimistic and optimistic estimates of the returns associated with each. The three
estimates for each asset, along with its range, are given in Table 5.3. Asset A
appears to be less risky than asset B; its range of 4% (17% 13%) is less than
the range of 16% (23% 7%) for asset B. The risk-averse decision maker would
prefer asset A over asset B, because A offers the same most likely return as B
(15%) with lower risk (smaller range).
TABLE 5.3
Assets A and B
Initial investment
Annual rate of return
Pessimistic
Most likely
Optimistic
Range
Asset A
Asset B
$10,000
$10,000
13%
15%
17%
7%
15%
23%
4%
16%
5. The term sensitivity analysis is intentionally used in a general rather than a technically correct fashion here to simplify this discussion. A more technical and precise definition and discussion of this technique and of “scenario analysis” are presented in Chapter 10.
220
PART 2
Important Financial Concepts
Although the use of sensitivity analysis and the range is rather crude, it does
give the decision maker a feel for the behavior of returns, which can be used to
estimate the risk involved.
Probability Distributions
probability distribution
A model that relates probabilities
to the associated outcomes.
bar chart
The simplest type of probability
distribution; shows only a limited
number of outcomes and associated probabilities for a given
event.
continuous probability
distribution
A probability distribution
showing all the possible
outcomes and associated
probabilities for a given event.
FIGURE 5.2
Bar Charts
Bar charts for asset A’s and
asset B’s returns
Norman Company’s past estimates indicate that the probabilities of the pessimistic, most likely, and optimistic outcomes are 25%, 50%, and 25%, respectively. Note that the sum of these probabilities must equal 100%; that is, they
must be based on all the alternatives considered.
A probability distribution is a model that relates probabilities to the associated outcomes. The simplest type of probability distribution is the bar chart,
which shows only a limited number of outcome–probability coordinates. The bar
charts for Norman Company’s assets A and B are shown in Figure 5.2. Although
both assets have the same most likely return, the range of return is much greater,
or more dispersed, for asset B than for asset A—16 percent versus 4 percent.
If we knew all the possible outcomes and associated probabilities, we could
develop a continuous probability distribution. This type of distribution can be
thought of as a bar chart for a very large number of outcomes.6 Figure 5.3 presents continuous probability distributions for assets A and B.7 Note that although
assets A and B have the same most likely return (15 percent), the distribution of
Asset A
.60
.50
.40
.30
.20
.10
0 5
9 13 17 21 25
Return (%)
Probability of Occurrence
EXAMPLE
Probability distributions provide a more quantitative insight into an asset’s risk.
The probability of a given outcome is its chance of occurring. An outcome with
an 80 percent probability of occurrence would be expected to occur 8 out of 10
times. An outcome with a probability of 100 percent is certain to occur. Outcomes with a probability of zero will never occur.
Probability of Occurrence
probability
The chance that a given outcome
will occur.
Asset B
.60
.50
.40
.30
.20
.10
0 5
9 13 17 21 25
Return (%)
6. To develop a continuous probability distribution, one must have data on a large number of historical occurrences
for a given event. Then, by developing a frequency distribution indicating how many times each outcome has
occurred over the given time horizon, one can convert these data into a probability distribution. Probability distributions for risky events can also be developed by using simulation—a process discussed briefly in Chapter 10.
7. The continuous distribution’s probabilities change because of the large number of additional outcomes considered. The area under each of the curves is equal to 1, which means that 100% of the outcomes, or all the possible
outcomes, are considered.
CHAPTER 5
Risk and Return
221
Probability Density
FIGURE 5.3
Continuous Probability
Distributions
Continuous probability
distributions for asset A’s
and asset B’s returns
Asset A
Asset B
0
5
7
9
11 13 15 17 19 21 23 25
Return (%)
returns for asset B has much greater dispersion than the distribution for asset A.
Clearly, asset B is more risky than asset A.
Risk Measurement
In addition to considering its range, the risk of an asset can be measured quantitatively by using statistics. Here we consider two statistics—the standard deviation and the coefficient of variation—that can be used to measure the variability
of asset returns.
Standard Deviation
standard deviation (k)
The most common statistical
indicator of an asset’s risk; it
measures the dispersion around
the expected value.
expected value of a return (k)
The most likely return on a given
asset.
The most common statistical indicator of an asset’s risk is the standard deviation,
k, which measures the dispersion around the expected value.8 The expected value
of a return, k, is the most likely return on an asset. It is calculated as follows:9
n
k
kj Prj
(5.2)
j1
where
kj return for the jth outcome
Prj probability of occurrence of the jth outcome
n number of outcomes considered
8. Although risk is typically viewed as determined by the dispersion of outcomes around an expected value, many
people believe that risk exists only when outcomes are below the expected value, because only returns below the
expected value are considered bad. Nevertheless, the common approach is to view risk as determined by the variability on either side of the expected value, because the greater this variability, the less confident one can be of the
outcomes associated with an investment.
, when all of the outcomes, kj, are known and their related
9. The formula for finding the expected value of return, k
probabilities are assumed to be equal, is a simple arithmetic average:
n
k
kj
j1
(5.2a)
n
where n is the number of observations. Equation 5.2 is emphasized in this chapter because returns and related probabilities are often available.
222
PART 2
Important Financial Concepts
TABLE 5.4
Possible
outcomes
Expected Values of Returns for
Assets A and B
Probability
(1)
Returns
(2)
Weighted value
[(1) (2)]
(3)
Asset A
Pessimistic
Most likely
Optimistic
Total
.25
.50
.2
5
13%
15
17
1
.00
Expected return
3.25%
7.50
4.25
15.00%
Asset B
Pessimistic
Most likely
Optimistic
Total
EXAMPLE
.25
.50
.2
5
7%
15
23
1
.0
0
Expected return
1.75%
7.50
5.75
15.00%
The expected values of returns for Norman Company’s assets A and B are presented in Table 5.4. Column 1 gives the Prj’s and column 2 gives the kj’s. In each
case n equals 3. The expected value for each asset’s return is 15%.
The expression for the standard deviation of returns, k, is10
k (kj )2 Pr
k
j1
j
n
(5.3)
In general, the higher the standard deviation, the greater the risk.
EXAMPLE
Table 5.5 presents the standard deviations for Norman Company’s assets A and
B, based on the earlier data. The standard deviation for asset A is 1.41%, and the
standard deviation for asset B is 5.66%. The higher risk of asset B is clearly
reflected in its higher standard deviation.
Historical Returns and Risk We can now use the standard deviation as a
measure of risk to assess the historical (1926–2000) investment return data in
Table 5.2. Table 5.6 repeats the historical returns and shows the standard deviations associated with each of them. A close relationship can be seen between the
investment returns and the standard deviations: Investments with higher returns
have higher standard deviations. Because higher standard deviations are associated with greater risk, the historical data confirm the existence of a positive rela-
10. The formula that is commonly used to find the standard deviation of returns, k, in a situation in which all outcomes are known and their related probabilities are assumed equal, is
n
k (kj k)2
j1
n1
(5.3a)
where n is the number of observations. Equation 5.3 is emphasized in this chapter because returns and related probabilities are often available.
CHAPTER 5
TABLE 5.5
i
kj
Risk and Return
223
The Calculation of the Standard Deviation
of the Returns for Assets A and Ba
k
kj k
(kj k)2
(kj k
)2 Prj
Prj
Asset A
1
2
3
13%
15
17
2%
0
2
15%
15
15
4%
0
4
.25
.50
.25
1%
0
1
3
(kj k)2 Prj j1
2%
3
k A
(kj k)2 Prj 2%
1.41%
j1
Asset B
1
2
3
7%
15
23
15%
15
15
8%
0
8
64%
0
64
.25
.50
.25
16%
0
1
6
3
(kj k)2 Prj 32%
j1
3
kB % 5.66%
(kj k)2 Prj 32
j1
aCalculations in this table are made in percentage form rather than decimal form—e.g., 13%
rather than 0.13. As a result, some of the intermediate computations may appear to be inconsistent with those that would result from using decimal form. Regardless, the resulting standard deviations are correct and identical to those that would result from using decimal rather
than percentage form.
tionship between risk and return. That relationship reflects risk aversion by market participants, who require higher returns as compensation for greater risk. The
historical data in Table 5.6 clearly show that during the 1926–2000 period,
investors were rewarded with higher returns on higher-risk investments.
TABLE 5.6
Historical Returns and Standard
Deviations for Selected Security
Investments (1926–2000)
Investment
Large-company stocks
Small-company stocks
Long-term corporate bonds
Long-term government bonds
U.S. Treasury bills
Inflation
Average annual return
Standard deviation
13.0%
17.3
6.0
5.7
3.9
20.2%
33.4
8.7
9.4
3.2
3.2%
4.4%
Source: Stocks, Bonds, Bills, and Inflation, 2001 Yearbook (Chicago: Ibbotson Associates,
Inc., 2001).
224
PART 2
Important Financial Concepts
Bell-Shaped Curve
Normal probability distribution, with ranges
Probability Density
FIGURE 5.4
68%
95%
99%
0
–3σk
–2σk
–1σk
k
+1σk +2σk +3σk
Return (%)
normal probability distribution
A symmetrical probability distribution whose shape resembles a
“bell-shaped” curve.
EXAMPLE
Normal Distribution A normal probability distribution, depicted in Figure
5.4, always resembles a “bell-shaped” curve. It is symmetrical: From the peak of
the graph, the curve’s extensions are mirror images (reflections) of each other.
The symmetry of the curve means that half the probability is associated with the
values to the left of the peak and half with the values to the right. As noted on the
figure, for normal probability distributions, 68 percent of the possible outcomes
will lie between 1 standard deviation from the expected value, 95 percent of all
outcomes will lie between 2 standard deviations from the expected value, and
99 percent of all outcomes will lie between 3 standard deviations from the
expected value.11
If we assume that the probability distribution of returns for the Norman Company
is normal, 68% of the possible outcomes would have a return ranging between
13.59 and 16.41% for asset A and between 9.34 and 20.66% for asset B; 95% of
the possible return outcomes would range between 12.18 and 17.82% for asset A
and between 3.68 and 26.32% for asset B; and 99% of the possible return outcomes
would range between 10.77 and 19.23% for asset A and between 1.98 and
31.98% for asset B. The greater risk of asset B is clearly reflected in its much wider
range of possible returns for each level of confidence (68%, 95%, etc.).
Coefficient of Variation
coefficient of variation (CV )
A measure of relative dispersion
that is useful in comparing the
risks of assets with differing
expected returns.
The coefficient of variation, CV, is a measure of relative dispersion that is useful
in comparing the risks of assets with differing expected returns. Equation 5.4
gives the expression for the coefficient of variation:
k
CV k
(5.4)
The higher the coefficient of variation, the greater the risk.
11. Tables of values indicating the probabilities associated with various deviations from the expected value of a normal distribution can be found in any basic statistics text. These values can be used to establish confidence limits and
make inferences about possible outcomes. Such applications can be found in most basic statistics and upper-level
managerial finance textbooks.
CHAPTER 5
EXAMPLE
Risk and Return
225
When the standard deviations (from Table 5.5) and the expected returns (from
Table 5.4) for assets A and B are substituted into Equation 5.4, the coefficients of
variation for A and B are 0.094 (1.41% 15%) and 0.377 (5.66% 15%),
respectively. Asset B has the higher coefficient of variation and is therefore more
risky than asset A—which we already know from the standard deviation.
(Because both assets have the same expected return, the coefficient of variation
has not provided any new information.)
The real utility of the coefficient of variation comes in comparing the risks of
assets that have different expected returns.
EXAMPLE
A firm wants to select the less risky of two alternative assets—X and Y. The
expected return, standard deviation, and coefficient of variation for each of these
assets’ returns are
Statistics
(1) Expected return
aPreferred
Asset Y
12%
20%
9%a
(2) Standard deviation
(3) Coefficient of variation [(2)
Asset X
(1)]
0.75
10%
0.50a
asset using the given risk measure.
Judging solely on the basis of their standard deviations, the firm would prefer
asset X, which has a lower standard deviation than asset Y (9% versus 10%).
However, management would be making a serious error in choosing asset X over
asset Y, because the dispersion—the risk—of the asset, as reflected in the coefficient of variation, is lower for Y (0.50) than for X (0.75). Clearly, using the coefficient of variation to compare asset risk is effective because it also considers the
relative size, or expected return, of the assets.
Review Questions
5–4
5–5
5–6
5–7
LG3
LG4
Explain how the range is used in sensitivity analysis.
What does a plot of the probability distribution of outcomes show a decision maker about an asset’s risk?
What relationship exists between the size of the standard deviation and
the degree of asset risk?
When is the coefficient of variation preferred over the standard deviation
for comparing asset risk?
5.3 Risk of a Portfolio
In real-world situations, the risk of any single investment would not be viewed
independently of other assets. (We did so for teaching purposes.) New investments must be considered in light of their impact on the risk and return of the
226
PART 2
Important Financial Concepts
efficient portfolio
A portfolio that maximizes return
for a given level of risk or
minimizes risk for a given level
of return.
portfolio of assets.12 The financial manager’s goal is to create an efficient portfolio, one that maximizes return for a given level of risk or minimizes risk for a
given level of return. We therefore need a way to measure the return and the standard deviation of a portfolio of assets. Once we can do that, we will look at the
statistical concept of correlation, which underlies the process of diversification
that is used to develop an efficient portfolio.
Portfolio Return and Standard Deviation
The return on a portfolio is a weighted average of the returns on the individual
assets from which it is formed. We can use Equation 5.5 to find the portfolio
return, kp:
n
kp (w1 k1) (w2 k2) . . . (wn kn) wj kj
(5.5)
j1
where
wj proportion of the portfolio’s total dollar value represented by asset j
kj return on asset j
n
Of course, j=1 wj 1, which means that 100 percent of the portfolio’s assets
must be included in this computation.
The standard deviation of a portfolio’s returns is found by applying the formula for the standard deviation of a single asset. Specifically, Equation 5.3 is
used when the probabilities of the returns are known, and Equation 5.3a (from
footnote 10) is applied when the outcomes are known and their related probabilities of occurrence are assumed to be equal.
EXAMPLE
Assume that we wish to determine the expected value and standard deviation of
returns for portfolio XY, created by combining equal portions (50%) of assets X
and Y. The forecasted returns of assets X and Y for each of the next 5 years
(2004–2008) are given in columns 1 and 2, respectively, in part A of Table 5.7. In
column 3, the weights of 50% for both assets X and Y along with their respective
returns from columns 1 and 2 are substituted into Equation 5.5. Column 4 shows
the results of the calculation—an expected portfolio return of 12% for each year,
2004 to 2008.
Furthermore, as shown in part B of Table 5.7, the expected value of these
portfolio returns over the 5-year period is also 12% (calculated by using Equation 5.2a, in footnote 9). In part C of Table 5.7, portfolio XY’s standard deviation is calculated to be 0% (using Equation 5.3a, in footnote 10). This value
should not be surprising because the expected return each year is the same—
12%. No variability is exhibited in the expected returns from year to year.
12. The portfolio of a firm, which would consist of its total assets, is not differentiated from the portfolio of an
owner, which would probably contain a variety of different investment vehicles (i.e., assets). The differing characteristics of these two types of portfolios should become clear upon completion of Chapter 10.
CHAPTER 5
TABLE 5.7
Risk and Return
227
Expected Return, Expected Value, and Standard
Deviation of Returns for Portfolio XY
A. Expected portfolio returns
Forecasted return
Year
Asset X
(1)
Asset Y
(2)
Portfolio return calculationa
(3)
Expected portfolio
return, kp
(4)
16%
(.50 8%) (.50 16%) 12%
2005
10
14
(.50 10%) (.50 14%) 12
2006
12
12
(.50 12%) (.50 12%) 12
2007
14
10
(.50 14%) (.50 10%) 12
2008
16
8
(.50 16%) (.50 8%) 12
2004
8%
B. Expected value of portfolio returns, 2004–2008b
12% 12% 12% 12% 12%
60%
p 12%
k
5
5
C. Standard deviation of expected portfolio returnsc
kp (12% 12%)2 (12% 12%)2 (12% 12%)2 (12% 12%)2 (12% 12%)2
51
0% 0% 0% 0% 0%
4
0
% 0%
4
aUsing
Equation 5.5.
Equation 5.2a found in footnote 9.
cUsing Equation 5.3a found in footnote 10.
bUsing
correlation
A statistical measure of the
relationship between any two
series of numbers representing
data of any kind.
positively correlated
Describes two series that move
in the same direction.
negatively correlated
Describes two series that move
in opposite directions.
Correlation
Correlation is a statistical measure of the relationship between any two series of
numbers. The numbers may represent data of any kind, from returns to test
scores. If two series move in the same direction, they are positively correlated. If
the series move in opposite directions, they are negatively correlated.13
13. The general long-term trends of two series could be the same (both increasing or both decreasing) or different
(one increasing, the other decreasing), and the correlation of their short-term (point-to-point) movements in both
situations could be either positive or negative. In other words, the pattern of movement around the trends could be
correlated independent of the actual relationship between the trends. Further clarification of this seemingly inconsistent behavior can be found in most basic statistics texts.
Important Financial Concepts
FIGURE 5.5
Correlations
The correlation between
series M and series N
Perfectly Positively Correlated
Perfectly Negatively Correlated
N
Return
PART 2
Return
228
N
M
M
Time
Time
correlation coefficient
A measure of the degree of
correlation between two series.
perfectly positively correlated
Describes two positively
correlated series that have a
correlation coefficient of 1.
perfectly negatively correlated
Describes two negatively
correlated series that have a
correlation coefficient of 1.
uncorrelated
Describes two series that lack
any interaction and therefore
have a correlation coefficient
close to zero.
The degree of correlation is measured by the correlation coefficient, which
ranges from 1 for perfectly positively correlated series to 1 for perfectly negatively correlated series. These two extremes are depicted for series M and N in
Figure 5.5. The perfectly positively correlated series move exactly together; the perfectly negatively correlated series move in exactly opposite directions.
Diversification
The concept of correlation is essential to developing an efficient portfolio. To
reduce overall risk, it is best to combine, or add to the portfolio, assets that have
a negative (or a low positive) correlation. Combining negatively correlated assets
can reduce the overall variability of returns. Figure 5.6 shows that a portfolio
containing the negatively correlated assets F and G, both of which have the same
expected return, k, also has that same return k but has less risk (variability) than
either of the individual assets. Even if assets are not negatively correlated, the
lower the positive correlation between them, the lower the resulting risk.
Some assets are uncorrelated—that is, there is no interaction between their
returns. Combining uncorrelated assets can reduce risk, not so effectively as combining negatively correlated assets, but more effectively than combining positively
correlated assets. The correlation coefficient for uncorrelated assets is close to zero
and acts as the midpoint between perfect positive and perfect negative correlation.
FIGURE 5.6
Diversification
Combining negatively
correlated assets to diversify
risk
Asset F
Return
Asset G
Return
Portfolio of
Assets F and G
Return
k
k
Time
Time
Time
CHAPTER 5
Risk and Return
229
The creation of a portfolio that combines two assets with perfectly positively
correlated returns results in overall portfolio risk that at minimum equals that of
the least risky asset and at maximum equals that of the most risky asset. However, a portfolio combining two assets with less than perfectly positive correlation can reduce total risk to a level below that of either of the components, which
in certain situations may be zero. For example, assume that you manufacture
machine tools. The business is very cyclical, with high sales when the economy is
expanding and low sales during a recession. If you acquired another machinetool company, with sales positively correlated with those of your firm, the combined sales would still be cyclical and risk would remain the same. Alternatively,
however, you could acquire a sewing machine manufacturer, whose sales are
countercyclical. It typically has low sales during economic expansion and high
sales during recession (when consumers are more likely to make their own
clothes). Combination with the sewing machine manufacturer, which has negatively correlated sales, should reduce risk.
EXAMPLE
TABLE 5.8
Table 5.8 presents the forecasted returns from three different assets—X, Y, and
Z—over the next 5 years, along with their expected values and standard deviations. Each of the assets has an expected value of return of 12% and a standard
Forecasted Returns, Expected Values, and Standard Deviations for
Assets X, Y, and Z and Portfolios XY and XZ
Assets
Portfolios
XYa
Year
X
2004
8%
Y
16%
Z
8%
(50%X 50%Y)
12%
XZb
(50%X 50%Z)
8%
2005
10
14
10
12
10
2006
12
12
12
12
12
2007
14
10
14
12
14
2008
16
8
16
12
16
Statistics:
c
Expected value
Standard deviationd
12%
12%
12%
12%
12%
3.16%
3.16%
3.16%
0%
3.16%
aPortfolio
XY, which consists of 50% of asset X and 50% of asset Y, illustrates perfect negative correlation because these two return streams
behave in completely opposite fashion over the 5-year period. Its return values shown here were calculated in part A of Table 5.7.
bPortfolio XZ, which consists of 50% of asset X and 50% of asset Z, illustrates perfect positive correlation because these two return streams
behave identically over the 5-year period. Its return values were calculated by using the same method demonstrated for portfolio XY in part A of
Table 5.7.
cBecause the probabilities associated with the returns are not given, the general equations, Equation 5.2a in footnote 9 and Equation 5.3a in footnote 10, were used to calculate expected values and standard deviations, respectively. Calculation of the expected value and standard deviation for
portfolio XY is demonstrated in parts B and C, respectively, of Table 5.7.
d The
portfolio standard deviations can be directly calculated from the standard deviations of the component assets with the following formula:
kp w12 12 w22 22 2w1w2r1,212
where w1 and w2 are the proportions of component assets 1 and 2, 1 and 2 are the standard deviations of component assets 1 and 2, and r1,2 is
the correlation coefficient between the returns of component assets 1 and 2.
230
PART 2
Important Financial Concepts
deviation of 3.16%. The assets therefore have equal return and equal risk. The
return patterns of assets X and Y are perfectly negatively correlated. They move
in exactly opposite directions over time. The returns of assets X and Z are perfectly positively correlated. They move in precisely the same direction. (Note: The
returns for X and Z are identical.)14
Portfolio XY Portfolio XY (shown in Table 5.8) is created by combining equal
portions of assets X and Y, the perfectly negatively correlated assets.15 (Calculation of portfolio XY’s annual expected returns, their expected value, and the
standard deviation of expected portfolio returns was demonstrated in Table 5.7.)
The risk in this portfolio, as reflected by its standard deviation, is reduced to 0%,
whereas the expected return remains at 12%. Thus the combination results in the
complete elimination of risk. Whenever assets are perfectly negatively correlated,
an optimal combination (similar to the 50–50 mix in the case of assets X and Y)
exists for which the resulting standard deviation will equal 0.
Portfolio XZ Portfolio XZ (shown in Table 5.8) is created by combining equal
portions of assets X and Z, the perfectly positively correlated assets. The risk in
this portfolio, as reflected by its standard deviation, is unaffected by this combination. Risk remains at 3.16%, and the expected return value remains at 12%.
Because assets X and Z have the same standard deviation, the minimum and
maximum standard deviations are the same (3.16%).
Correlation, Diversification,
Risk, and Return
Hint Remember, low
correlation between two series
of numbers is less positive and
more negative—indicating
greater dissimilarity of behavior
of the two series.
In general, the lower the correlation between asset returns, the greater the potential diversification of risk. (This should be clear from the behaviors illustrated in
Table 5.8.) For each pair of assets, there is a combination that will result in the
lowest risk (standard deviation) possible. How much risk can be reduced by this
combination depends on the degree of correlation. Many potential combinations
(assuming divisibility) could be made, but only one combination of the infinite
number of possibilities will minimize risk.
Three possible correlations—perfect positive, uncorrelated, and perfect negative—illustrate the effect of correlation on the diversification of risk and return.
Table 5.9 summarizes the impact of correlation on the range of return and risk
for various two-asset portfolio combinations. The table shows that as we move
from perfect positive correlation to uncorrelated assets to perfect negative correlation, the ability to reduce risk is improved. Note that in no case will a portfolio
of assets be riskier than the riskiest asset included in the portfolio.
14. Identical return streams are used in this example to permit clear illustration of the concepts, but it is not necessary for return streams to be identical for them to be perfectly positively correlated. Any return streams that move
(i.e., vary) exactly together—regardless of the relative magnitude of the returns—are perfectly positively correlated.
15. For illustrative purposes it has been assumed that each of the assets—X, Y, and Z—can be divided up and combined with other assets to create portfolios. This assumption is made only to permit clear illustration of the concepts.
The assets are not actually divisible.
CHAPTER 5
TABLE 5.9
Correlation, Return, and Risk for Various
Two-Asset Portfolio Combinations
Correlation
coefficient
EXAMPLE
231
Risk and Return
Range of return
Range of risk
1 (perfect positive)
Between returns of two assets
held in isolation
Between risk of two assets held
in isolation
0 (uncorrelated)
Between returns of two assets
held in isolation
Between risk of most risky asset
and an amount less than risk
of least risky asset but greater
than 0
1 (perfect negative)
Between returns of two assets
held in isolation
Between risk of most risky asset
and 0
A firm has calculated the expected return and the risk for each of two assets—R
and S.
Asset
Expected return, k
Risk (standard deviation), R
S
6%
8
3%
8
Clearly, asset R is a lower-return, lower-risk asset than asset S.
To evaluate possible combinations, the firm considered three possible correlations—perfect positive, uncorrelated, and perfect negative. The results of the
analysis are shown in Figure 5.7, using the ranges of return and risk noted above.
In all cases, the return will range between the 6% return of R and the 8% return
of S. The risk, on the other hand, ranges between the individual risks of R and S
(from 3% to 8%) in the case of perfect positive correlation, from below 3% (the
risk of R) and greater than 0% to 8% (the risk of S) in the uncorrelated case, and
between 0% and 8% (the risk of S) in the perfectly negatively correlated case.
FIGURE 5.7
Possible Correlations
Range of portfolio return (kp)
and risk (kp) for combinations of assets R and
S for various correlation
coefficients
Correlation
Coefficient
Ranges of Risk
Ranges of Return
+1 (Perfect Positive)
+1
0 (Uncorrelated)
0
–1
–1 (Perfect Negative)
0
5
6
kR
7
8
9
kS
Portfolio Return (%)
(kp)
0 1 2 3 4 5 6 7 8 9
σk
σk
R
S
Portfolio Risk (%)
(σkp)
232
PART 2
Important Financial Concepts
Note that only in the case of perfect negative correlation can the risk be
reduced to 0. Also note that as the correlation becomes less positive and more
negative (moving from the top of the figure down), the ability to reduce risk
improves. The amount of risk reduction achieved depends on the proportions in
which the assets are combined. Although determining the risk-minimizing combination is beyond the scope of this discussion, it is an important issue in developing portfolios of assets.
International Diversification
The ultimate example of portfolio diversification involves including foreign assets
in a portfolio. The inclusion of assets from countries with business cycles that are
not highly correlated with the U.S. business cycle reduces the portfolio’s responsiveness to market movements and to foreign currency fluctuations.
Returns from International Diversification
Over long periods, returns from internationally diversified portfolios tend to be
superior to those of purely domestic ones. This is particularly so if the U.S. economy is performing relatively poorly and the dollar is depreciating in value against
most foreign currencies. At such times, the dollar returns to U.S. investors on a
portfolio of foreign assets can be very attractive. However, over any single short
or intermediate period, international diversification can yield subpar returns, particularly during periods when the dollar is appreciating in value relative to other
currencies. When the U.S. currency gains in value, the dollar value of a foreigncurrency-denominated portfolio of assets declines. Even if this portfolio yields a
satisfactory return in local currency, the return to U.S. investors will be reduced
when translated into dollars. Subpar local currency portfolio returns, coupled
with an appreciating dollar, can yield truly dismal dollar returns to U.S. investors.
Overall, though, the logic of international portfolio diversification assumes
that these fluctuations in currency values and relative performance will average
out over long periods. Compared to similar, purely domestic portfolios, an internationally diversified portfolio will tend to yield a comparable return at a lower
level of risk.
Risks of International Diversification
political risk
Risk that arises from the
possibility that a host government will take actions harmful to
foreign investors or that political
turmoil in a country will
endanger investments there.
U.S. investors should also be aware of the potential dangers of international
investing. In addition to the risk induced by currency fluctuations, several other
financial risks are unique to international investing. Most important is political
risk, which arises from the possibility that a host government will take actions
harmful to foreign investors or that political turmoil in a country will endanger
investments there. Political risks are particularly acute in developing countries,
where unstable or ideologically motivated governments may attempt to block
return of profits by foreign investors or even seize (nationalize) their assets in the
host country. An example of political risk was the heightened concern after
Desert Storm in the early 1990s that Saudi Arabian fundamentalists would take
over and nationalize the U.S. oil facilities located there.
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Risk and Return
233
Even where governments do not impose exchange controls or seize assets,
international investors may suffer if a shortage of hard currency prevents payment
of dividends or interest to foreigners. When governments are forced to allocate
scarce foreign exchange, they rarely give top priority to the interests of foreign
investors. Instead, hard-currency reserves are typically used to pay for necessary
imports such as food, medicine, and industrial materials and to pay interest on the
government’s debt. Because most of the debt of developing countries is held by
banks rather than individuals, foreign investors are often badly harmed when a
country experiences political or economic problems.
Review Questions
5–8
What is an efficient portfolio? How can the return and standard deviation
of a portfolio be determined?
5–9 Why is the correlation between asset returns important? How does diversification allow risky assets to be combined so that the risk of the portfolio
is less than the risk of the individual assets in it?
5–10 How does international diversification enhance risk reduction? When
might international diversification result in subpar returns? What are
political risks, and how do they affect international diversification?
LG5
LG6
5.4 Risk and Return: The Capital Asset
Pricing Model (CAPM)
capital asset pricing model
(CAPM)
The basic theory that links risk
and return for all assets.
The most important aspect of risk is the overall risk of the firm as viewed by
investors in the marketplace. Overall risk significantly affects investment opportunities and—even more important—the owners’ wealth. The basic theory that
links risk and return for all assets is the capital asset pricing model (CAPM).16 We
will use CAPM to understand the basic risk–return tradeoffs involved in all types
of financial decisions.
Types of Risk
To understand the basic types of risk, consider what happens to the risk of a
portfolio consisting of a single security (asset), to which we add securities randomly selected from, say, the population of all actively traded securities. Using
16. The initial development of this theory is generally attributed to William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” Journal of Finance 19 (September 1964), pp. 425–442, and
John Lintner, “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital
Budgets,” Review of Economics and Statistics 47 (February 1965), pp 13–37. A number of authors subsequently
advanced, refined, and tested this now widely accepted theory.
234
PART 2
Important Financial Concepts
Risk Reduction
Portfolio risk and
diversification
Portfolio Risk, σkP
FIGURE 5.8
Diversifiable Risk
Total Risk
Nondiversifiable Risk
1
total risk
The combination of a security’s
nondiversifiable and diversifiable risk.
5
10
15
20
25
Number of Securities (Assets) in Portfolio
the standard deviation of return, kp, to measure the total portfolio risk, Figure
5.8 depicts the behavior of the total portfolio risk (y axis) as more securities are
added (x axis). With the addition of securities, the total portfolio risk declines, as
a result of the effects of diversification, and tends to approach a lower limit.
Research has shown that, on average, most of the risk-reduction benefits of diversification can be gained by forming portfolios containing 15 to 20 randomly
selected securities.17
The total risk of a security can be viewed as consisting of two parts:
Total security risk Nondiversifiable risk Diversifiable risk
diversifiable risk
The portion of an asset’s risk that
is attributable to firm-specific,
random causes; can be eliminated through diversification.
Also called unsystematic risk.
nondiversifiable risk
The relevant portion of an asset’s
risk attributable to market
factors that affect all firms;
cannot be eliminated through
diversification. Also called
systematic risk.
(5.6)
Diversifiable risk (sometimes called unsystematic risk) represents the portion of
an asset’s risk that is associated with random causes that can be eliminated
through diversification. It is attributable to firm-specific events, such as strikes,
lawsuits, regulatory actions, and loss of a key account. Nondiversifiable risk (also
called systematic risk) is attributable to market factors that affect all firms; it cannot be eliminated through diversification. (It is the shareholder-specific market
risk described in Table 5.1.) Factors such as war, inflation, international incidents, and political events account for nondiversifiable risk.
Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is nondiversifiable risk. Any
investor or firm therefore must be concerned solely with nondiversifiable risk.
The measurement of nondiversifiable risk is thus of primary importance in selecting assets with the most desired risk–return characteristics.
17. See, for example, W. H. Wagner and S. C. Lau, “The Effect of Diversification on Risk,” Financial Analysts Journal 26 (November–December 1971), pp. 48–53, and Jack Evans and Stephen H. Archer, “Diversification and the
Reduction of Dispersion: An Empirical Analysis,” Journal of Finance 23 (December 1968), pp. 761–767. A more
recent study, Gerald D. Newbould and Percy S. Poon, “The Minimum Number of Stocks Needed for Diversification,” Financial Practice and Education (Fall 1993), pp. 85–87, shows that because an investor holds but one of a
large number of possible x-security portfolios, it is unlikely that he or she will experience the average outcome. As a
consequence, the study suggests that a minimum of 40 stocks is needed to diversify a portfolio fully. This study tends
to support the widespread popularity of mutual fund investments.
CHAPTER 5
Risk and Return
235
The Model: CAPM
The capital asset pricing model (CAPM) links nondiversifiable risk and return
for all assets. We will discuss the model in five sections. The first deals with
the beta coefficient, which is a measure of nondiversifiable risk. The second
section presents an equation of the model itself, and the third graphically
describes the relationship between risk and return. The fourth section discusses
the effects of changes in inflationary expectations and risk aversion on the relationship between risk and return. The final section offers some comments on
the CAPM.
Beta Coefficient
beta coefficient (b)
A relative measure of nondiversifiable risk. An index of the
degree of movement of an asset’s
return in response to a change in
the market return.
market return
The return on the market portfolio of all traded securities.
The beta coefficient, b, is a relative measure of nondiversifiable risk. It is an
index of the degree of movement of an asset’s return in response to a change in
the market return. An asset’s historical returns are used in finding the asset’s beta
coefficient. The market return is the return on the market portfolio of all traded
securities. The Standard & Poor’s 500 Stock Composite Index or some similar
stock index is commonly used as the market return. Betas for actively traded
stocks can be obtained from a variety of sources, but you should understand how
they are derived and interpreted and how they are applied to portfolios.
Deriving Beta from Return Data An asset’s historical returns are used in
finding the asset’s beta coefficient. Figure 5.9 plots the relationship between the
returns of two assets—R and S—and the market return. Note that the horizontal
(x) axis measures the historical market returns and that the vertical (y) axis measures the individual asset’s historical returns. The first step in deriving beta
involves plotting the coordinates for the market return and asset returns from
various points in time. Such annual “market return–asset return” coordinates are
shown for asset S only for the years 1996 through 2003. For example, in 2003,
asset S’s return was 20 percent when the market return was 10 percent. By use of
statistical techniques, the “characteristic line” that best explains the relationship
between the asset return and the market return coordinates is fit to the data
points.18 The slope of this line is beta. The beta for asset R is about .80 and that
18. The empirical measurement of beta is approached by using least-squares regression analysis to find the regression coefficient (bj) in the equation for the “characteristic line”:
kj aj bj km ej
where
kj return on asset j
aj intercept
Cov (kj, km)
bj beta coefficient, which equals 2
m
where
Cov (kj, km) covariance of the return on asset j, kj, and the return on the market portfolio, km
m2 variance of the return on the market portfolio
km required rate of return on the market portfolio of securities
ej random error term, which reflects the diversifiable, or unsystematic, risk of asset j
The calculations involved in finding betas are somewhat rigorous. If you want to know more about these calculations, consult an advanced managerial finance or investments text.
236
PART 2
Important Financial Concepts
FIGURE 5.9
Asset Return (%)
Beta Derivationa
Graphical derivation of beta
for assets R and S
(1997)
Asset S
35
30
(2002)
25
(2003)
20
10
(1996)
5
–20
–10
0
–5
(1999)
bS = slope = 1.30
(2000)
15
(1998)
(2001)
Asset R
bR = slope = .80
10 15 20 25 30 35
Market
Return (%)
–10
Characteristic Line S
–15
Characteristic Line R
–20
–25
–30
a All data points shown are associated with asset S. No data points are shown for asset R.
for asset S is about 1.30. Asset S’s higher beta (steeper characteristic line slope)
indicates that its return is more responsive to changing market returns. Therefore
asset S is more risky than asset R.19
Hint Remember that
published betas are calculated
using historical data. When
investors use beta for decision
making, they should recognize
that past performance relative
to the market average may not
accurately predict future
performance.
Interpreting Betas The beta coefficient for the market is considered to be
equal to 1.0. All other betas are viewed in relation to this value. Asset betas may
be positive or negative, but positive betas are the norm. The majority of beta
coefficients fall between .5 and 2.0. The return of a stock that is half as responsive as the market (b .5) is expected to change by 1/2 percent for each 1 percent
change in the return of the market portfolio. A stock that is twice as responsive as
the market (b 2.0) is expected to experience a 2 percent change in its return for
each 1 percent change in the return of the market portfolio. Table 5.10 provides
various beta values and their interpretations. Beta coefficients for actively traded
stocks can be obtained from published sources such as Value Line Investment
Survey, via the Internet, or through brokerage firms. Betas for some selected
stocks are given in Table 5.11.
Portfolio Betas The beta of a portfolio can be easily estimated by using the
betas of the individual assets it includes. Letting wj represent the proportion of
19. The values of beta also depend on the time interval used for return calculations and on the number of returns
used in the regression analysis. In other words, betas calculated using monthly returns would not necessarily be comparable to those calculated using a similar number of daily returns.
CHAPTER 5
TABLE 5.10
Beta
2.0
1.0
.5
Risk and Return
237
Selected Beta Coefficients and
Their Interpretations
Comment
Interpretation
Move in same
direction as
market
0
Twice as responsive as the market
Same response as the market
Only half as responsive as the market
Unaffected by market movement
.5
1.0
2.0
Move in opposite
direction to
market
TABLE 5.11
Only half as responsive as the market
Same response as the market
Twice as responsive as the market
Beta Coefficients for Selected Stocks
(March 8, 2002)
Stock
Beta
Amazon.com
1.95
Anheuser-Busch
.60
Bank One Corp.
Stock
Beta
Int’l Business Machines
1.05
Merrill Lynch & Co.
1.85
1.25
Microsoft
1.20
Daimler Chrysler AG
1.25
NIKE, Inc.
.90
Disney
1.05
PepsiCo, Inc.
eBay
2.20
Qualcomm
Exxon Mobil Corp.
.80
.70
1.30
Sempra Energy
.60
Gap (The), Inc.
1.60
Wal-Mart Stores
1.15
General Electric
1.30
Xerox
1.25
Intel
1.30
Yahoo! Inc.
2.00
Source: Value Line Investment Survey (New York: Value Line Publishing, March 8, 2002).
the portfolio’s total dollar value represented by asset j, and letting bj equal the
beta of asset j, we can use Equation 5.7 to find the portfolio beta, bp:
n
bp (w1 b1) (w2 b2) . . . (wn bn) wj bj
(5.7)
j1
n
Hint Mutual fund
managers are key users of the
portfolio beta and return
concepts. They are continually
evaluating what would happen
to the fund’s beta and return if
the securities of a particular
firm were added to or deleted
from the fund’s portfolio.
Of course, j=1 wj 1, which means that 100 percent of the portfolio’s assets
must be included in this computation.
Portfolio betas are interpreted in the same way as the betas of individual
assets. They indicate the degree of responsiveness of the portfolio’s return to
changes in the market return. For example, when the market return increases by
10 percent, a portfolio with a beta of .75 will experience a 7.5 percent increase in
its return (.75 10%); a portfolio with a beta of 1.25 will experience a 12.5 percent increase in its return (1.25 10%). Clearly, a portfolio containing mostly
low-beta assets will have a low beta, and one containing mostly high-beta assets
will have a high beta.
238
PART 2
Important Financial Concepts
TABLE 5.12
Austin Fund’s Portfolios
V and W
Portfolio V
Asset
Proportion
Beta
Proportion
1
.10
1.65
.10
.80
2
.30
1.00
.10
1.00
3
.20
1.30
.20
.65
4
.20
1.10
.10
.75
5
.20
1.00
1.25
.50
1.00
1.05
Totals
EXAMPLE
Portfolio W
Beta
The Austin Fund, a large investment company, wishes to assess the risk of two
portfolios it is considering assembling—V and W. Both portfolios contain five
assets, with the proportions and betas shown in Table 5.12. The betas for the two
portfolios, bv and bw, can be calculated by substituting data from the table into
Equation 5.7:
bv (.10 1.65) (.30 1.00) (.20 1.30) (.20 1.10) (.20 1.25)
.165 .300 .260 .220 .250 1.195 1.20
bw (.10 .80) (.10 1.00) (.20 .65) (.10 .75) (.50 1.05)
.080 .100 .130 .075 .525 .91
Portfolio V’s beta is 1.20, and portfolio W’s is .91. These values make sense,
because portfolio V contains relatively high-beta assets, and portfolio W contains
relatively low-beta assets. Clearly, portfolio V’s returns are more responsive to
changes in market returns and are therefore more risky than portfolio W’s.
The Equation
Using the beta coefficient to measure nondiversifiable risk, the capital asset pricing model (CAPM) is given in Equation 5.8:
kj RF [bj (km RF)]
(5.8)
where
risk-free rate of interest, RF
The required return on a risk-free
asset, typically a 3-month U.S.
Treasury bill.
U.S. Treasury bills (T-bills)
Short-term IOUs issued by the
U.S. Treasury; considered the
risk-free asset.
kj required return on asset j
RF risk-free rate of return, commonly measured by the
return on a U.S. Treasury bill
bj beta coefficient or index of nondiversifiable risk for asset j
km market return; return on the market portfolio of assets
The CAPM can be divided into two parts: (1) risk-free of interest, RF , which
is the required return on a risk-free asset, typically a 3-month U.S. Treasury bill
(T-bill), a short-term IOU issued by the U.S. Treasury, and (2) the risk premium.
These are, respectively, the two elements on either side of the plus sign in Equation 5.8. The (km RF) portion of the risk premium is called the market risk pre-
CHAPTER 5
Risk and Return
239
mium, because it represents the premium the investor must receive for taking the
average amount of risk associated with holding the market portfolio of assets.20
Historical Risk Premiums Using the historical return data for selected security investments for the 1926–2000 period shown in Table 5.2, we can calculate
the risk premiums for each investment category. The calculation (consistent with
Equation 5.8) involves merely subtracting the historical U.S. Treasury bill’s average return from the historical average return for a given investment:
Investment
Risk premiuma
Large-company stocks
13.0% 3.9% 9.1%
Small company stocks
17.3
3.9
13.4
Long-term corporate bonds
6.0
3.9
2.1
Long-term government bonds
5.7
3.9
1.8
U.S. Treasury bills
3.9
3.9
0.0
aReturn
values obtained from Table 5.2.
Reviewing the risk premiums calculated above, we can see that the risk premium is highest for small-company stocks, followed by large-company stocks,
long-term corporate bonds, and long-term government bonds. This outcome
makes sense intuitively because small-company stocks are riskier than largecompany stocks, which are riskier than long-term corporate bonds (equity is
riskier than debt investment). Long-term corporate bonds are riskier than longterm government bonds (because the government is less likely to renege on debt).
And of course, U.S. Treasury bills, because of their lack of default risk and their
very short maturity, are virtually risk-free, as indicated by their lack of any risk
premium.
EXAMPLE
Benjamin Corporation, a growing computer software developer, wishes to determine the required return on an asset Z, which has a beta of 1.5. The risk-free rate
of return is 7%; the return on the market portfolio of assets is 11%. Substituting
bz 1.5, RF 7%, and km 11% into the capital asset pricing model given in
Equation 5.8 yields a required return of
kz 7% [1.5 (11% 7%)] 7% 6% 13
%
The market risk premium of 4% (11% 7%), when adjusted for the asset’s
index of risk (beta) of 1.5, results in a risk premium of 6% (1.5 4%). That risk
premium, when added to the 7% risk-free rate, results in a 13% required return.
Other things being equal, the higher the beta, the higher the required return,
and the lower the beta, the lower the required return.
20. Although CAPM has been widely accepted, a broader theory, arbitrage pricing theory (APT), first described by
Stephen A. Ross, “The Arbitrage Theory of Capital Asset Pricing,” Journal of Economic Theory (December 1976),
pp. 341–360, has received a great deal of attention in the financial literature. The theory suggests that the risk premium on securities may be better explained by a number of factors underlying and in place of the market return used
in CAPM. The CAPM in effect can be viewed as being derived from APT. Although testing of APT theory confirms
the importance of the market return, it has thus far failed to identify other risk factors clearly. As a result of this failure, as well as APT’s lack of practical acceptance and usage, we concentrate our attention here on CAPM.
240
PART 2
Important Financial Concepts
The Graph: The Security Market Line (SML)
security market line (SML)
The depiction of the capital
asset pricing model (CAPM ) as a
graph that reflects the required
return in the marketplace for
each level of nondiversifiable
risk (beta).
EXAMPLE
When the capital asset pricing model (Equation 5.8) is depicted graphically, it is
called the security market line (SML). The SML will, in fact, be a straight line. It
reflects the required return in the marketplace for each level of nondiversifiable
risk (beta). In the graph, risk as measured by beta, b, is plotted on the x axis, and
required returns, k, are plotted on the y axis. The risk–return tradeoff is clearly
represented by the SML.
In the preceding example for Benjamin Corporation, the risk-free rate, RF, was
7%, and the market return, km, was 11%. The SML can be plotted by using the
two sets of coordinates for the betas associated with RF and km, bRF and bm (that
is, bRF 0,21 RF 7%; and bm 1.0, km 11%). Figure 5.10 presents the resulting security market line. As traditionally shown, the security market line in Figure
5.10 presents the required return associated with all positive betas. The market
risk premium of 4% (km of 11% RF of 7%) has been highlighted. For a beta for
asset Z, bz, of 1.5, its corresponding required return, kz, is 13%. Also shown in
the figure is asset Z’s risk premium of 6% (kz of 13% RF of 7%). It should be
clear that for assets with betas greater than 1, the risk premium is greater than
that for the market; for assets with betas less than 1, the risk premium is less than
that for the market.
Security Market Line
Security market line (SML)
with Benjamin Corporation’s
asset Z data shown
Required Return, k (%)
FIGURE 5.10
17
16
15
14
kz = 13
12
km = 11
10
9
8
RF = 7
6
5
4
3
2
1
SML
Asset Z’s
Risk
Premium
(6%)
Market
Risk
Premium
(4%)
0
bR
.5
F
1.0
1.5
bm
bz
2.0
Nondiversifiable Risk, b
21. Because RF is the rate of return on a risk-free asset, the beta associated with the risk-free asset, bRF, would equal
0. The 0 beta on the risk-free asset reflects not only its absence of risk but also that the asset’s return is unaffected by
movements in the market return.
CHAPTER 5
Risk and Return
241
Shifts in the Security Market Line
The security market line is not stable over time, and shifts in the security market
line can result in a change in required return. The position and slope of the SML
are affected by two major forces—inflationary expectations and risk aversion—
which are analyzed next.22
Changes in Inflationary Expectations Changes in inflationary expectations
affect the risk-free rate of return, RF. The equation for the risk-free rate of
return is
RF k* IP
(5.9)
This equation shows that, assuming a constant real rate of interest, k*, changes in
inflationary expectations, reflected in an inflation premium, IP, will result in corresponding changes in the risk-free rate. Therefore, a change in inflationary expectations that results from events such as international trade embargoes or major
changes in Federal Reserve policy will result in a shift in the SML. Because the riskfree rate is a basic component of all rates of return, any change in RF will be
reflected in all required rates of return.
Changes in inflationary expectations result in parallel shifts in the SML in
direct response to the magnitude and direction of the change. This effect can best
be illustrated by an example.
EXAMPLE
In the preceding example, using CAPM, the required return for asset Z, kZ, was
found to be 13%. Assuming that the risk-free rate of 7% includes a 2% real
rate of interest, k*, and a 5% inflation premium, IP, then Equation 5.9 confirms that
RF 2% 5% 7%
Now assume that recent economic events have resulted in an increase of 3%
in inflationary expectations, raising the inflation premium to 8% (IP1). As a
result, all returns likewise rise by 3%. In this case, the new returns (noted by subscript 1) are
RF1 10% (rises from 7% to 10%)
km1 14% (rises from 11% to 14%)
Substituting these values, along with asset Z’s beta (bZ) of 1.5, into the CAPM
(Equation 5.8), we find that asset Z’s new required return (kZ1) can be calculated:
kZ1 10% [1.5 (14% 10%)] 10% 6% 16%
Comparing kZ1 of 16% to kZ of 13%, we see that the change of 3% in asset Z’s
required return exactly equals the change in the inflation premium. The same 3%
increase results for all assets.
22. A firm’s beta can change over time as a result of changes in the firm’s asset mix, in its financing mix, or in external factors not within management’s control, such as earthquakes, toxic spills, and so on. The impacts of changes in
beta on value are discussed in Chapter 7.
242
PART 2
Important Financial Concepts
FIGURE 5.11
Required Return, k (%)
Inflation Shifts SML
Impact of increased inflationary expectations on the SML
SML1
17
kz = 16
1
15
km = 14
1
kz = 13
12
km = 11
RF = 10
1
9
8
RF = 7
6
5
4
3
2
1
SML
Inc.
in IP
IP1
IP
k*
0
bR
.5
F
1.0
1.5
bm
bz
2.0
Nondiversifiable Risk, b
Figure 5.11 depicts the situation just described. It shows that the 3% increase
in inflationary expectations results in a parallel shift upward of 3% in the SML.
Clearly, the required returns on all assets rise by 3%. Note that the rise in the
inflation premium from 5% to 8% (IP to IP1) causes the risk-free rate to rise from
7% to 10% (RF to RF1) and the market return to increase from 11% to 14% (km
to km1). The security market line therefore shifts upward by 3% (SML to SML1),
causing the required return on all risky assets, such as asset Z, to rise by 3%. It
should now be clear that a given change in inflationary expectations will be fully
reflected in a corresponding change in the returns of all assets, as reflected graphically in a parallel shift of the SML.
Changes in Risk Aversion The slope of the security market line reflects the
general risk preferences of investors in the marketplace. As discussed earlier and
shown in Figure 5.1, most investors are risk-averse—they require increased
returns for increased risk. This positive relationship between risk and return is
graphically represented by the SML, which depicts the relationship between nondiversifiable risk as measured by beta (x axis) and the required return (y axis).
The slope of the SML reflects the degree of risk aversion: the steeper its slope, the
greater the degree of risk aversion, because a higher level of return will be
required for each level of risk as measured by beta. In other words, risk premiums
increase with increasing risk avoidance.
Changes in risk aversion, and therefore shifts in the SML, result from changing preferences of investors, which generally result from economic, political, and
social events. Examples of events that increase risk aversion include a stock mar-
CHAPTER 5
Risk and Return
243
ket crash, assassination of a key political leader, and the outbreak of war. In general, widely accepted expectations of hard times ahead tend to cause investors to
become more risk-averse, requiring higher returns as compensation for accepting
a given level of risk. The impact of increased risk aversion on the SML can best be
demonstrated by an example.
EXAMPLE
In the preceding examples, the SML in Figure 5.10 reflected a risk-free rate (RF) of
7%, a market return (km) of 11%, a market risk premium (km RF) of 4%, and a
required return on asset Z (kZ) of 13% with a beta (bZ) of 1.5. Assume that recent
economic events have made investors more risk-averse, causing a new higher market return (km1) of 14%. Graphically, this change would cause the SML to shift
upward as shown in Figure 5.12, causing a new market risk premium (km1 RF)
of 7%. As a result, the required return on all risky assets will increase. For asset Z,
with a beta of 1.5, the new required return (kZ1) can be calculated by using
CAPM (Equation 5.8):
kZ1 7% [1.5 (14% 7%)] 7% 10.5% 17.5%
This value can be seen on the new security market line (SML1) in Figure 5.12.
Note that although asset Z’s risk, as measured by beta, did not change, its
required return has increased because of the increased risk aversion reflected in
FIGURE 5.12
Required Return, k (%)
Risk Aversion Shifts SML
Impact of increased risk
aversion on the SML
22
21
20
19
18
kZ = 17.5
1
17
16
15
km = 14
1
kZ = 13
12
km = 11
10
9
8
RF = 7
6
5
4
3
2
1
SML1
SML
New Market Risk Premium
km – RF = 7%
1
Initial Market
Risk Premium
km – RF = 4%
0
bR
.5
F
1.0
1.5
bm
bZ
Nondiversifiable Risk, b
2.0
244
PART 2
Important Financial Concepts
FOCUS ON PRACTICE
What’s at Risk? VAR Has the Answer
Financial managers, always on the
lookout for new ways to measure
and manage risk, have added
value-at -risk (VAR ) techniques to
their repertoire. VAR is a statistical
measure of risk exposure that reflects the potential loss from an
unlikely, adverse event in a normal,
everyday market environment. It
predicts the drop in a company’s
value that will occur if things go
wrong by calculating the financial
risk in the future market value of a
portfolio of assets, liabilities, and
equity.
First used by banks and brokerage firms to measure the risk of
market movements, VAR now has
proponents among nonfinancial
companies such as Xerox, General
Motors, and GTE. Unlike other risk
tools that measure risk using standard deviation, VAR is stated in
currency units: for example, VAR
would represent an amount, let’s
call it D dollars, where the chance
of losing more than D dollars is,
say, 1 in 50 over some future time
interval, perhaps a week.
VAR shows companies
whether they are properly diversified and also whether they have
sufficient capital. Among its
other benefits, it tells managers
whether their actions are too
cautious, identifies risk trouble
spots that might not be caught,
and provides a way to compare
business units that measure performance differently for internal
reporting.
For example, a bank could
take a diverse portfolio of financial
assets and calculate price swings
by measuring performance on
specific days in the past. Plotting
the percentage gain or loss for
hundreds of days would reveal the
In Practice
value at risk of that portfolio. If it
was riskier than previously
thought, traders could take corrective action—selling a particular
type of security, for example—to
reduce risk.
Like any quantitative model,
VAR has its limitations. Perhaps its
biggest drawback is its reliance on
historical patterns that may not
hold true in the future.
Sources: Steve Bergsman, “Delivering the
Risk Management Goods,” Treasury & Risk
Management, downloaded from www.
treasuryandrisk.com/trmtechguide/
article13.cgi; Peter Coy, “Taking the Angst
Out of Taking a Gamble,” Business Week
(July 14, 1997), pp. 52–53; and Paul Hom and
Ron Tonuzi, “Value-at-Risk: Safety Net or
Abyss?” Treasury & Risk Management
(November/December 1998), downloaded
from www.cfonet.com; Barry Schachter, “An
Irreverent Guide to Value at Risk,” All About
Value-at-Risk (Web site), downloaded from
www.gloriamundi.com.
the market risk premium. It should now be clear that greater risk aversion results
in higher required returns for each level of risk. Similarly, a reduction in risk
aversion causes the required return for each level of risk to decline.
Some Comments on CAPM
efficient market
A market with the following
characteristics: many small
investors, all having the same
information and expectations
with respect to securities; no
restrictions on investment, no
taxes, and no transaction costs;
and rational investors, who view
securities similarly and are riskaverse, preferring higher returns
and lower risk.
The capital asset pricing model generally relies on historical data. The betas may
or may not actually reflect the future variability of returns. Therefore, the
required returns specified by the model can be viewed only as rough approximations. Users of betas commonly make subjective adjustments to the historically
determined betas to reflect their expectations of the future.
The CAPM was developed to explain the behavior of security prices and provide a mechanism whereby investors could assess the impact of a proposed security investment on their portfolio’s overall risk and return. It is based on an
assumed efficient market with the following characteristics: many small investors,
all having the same information and expectations with respect to securities; no
restrictions on investment, no taxes, and no transaction costs; and rational
investors, who view securities similarly and are risk-averse, preferring higher
returns and lower risk.
Although the perfect world of the efficient market appears to be unrealistic,
studies have provided support for the existence of the expectational relationship
CHAPTER 5
Risk and Return
245
described by CAPM in active markets such as the New York Stock Exchange.23
In the case of real corporate assets, such as plant and equipment, research thus far
has failed to prove the general applicability of CAPM because of indivisibility,
relatively large size, limited number of transactions, and absence of an efficient
market for such assets.
Despite the limitations of CAPM, it provides a useful conceptual framework
for evaluating and linking risk and return. An awareness of this tradeoff and an
attempt to consider risk as well as return in financial decision making should help
financial managers achieve their goals.
Review Questions
5–11 How are total risk, nondiversifiable risk, and diversifiable risk related?
Why is nondiversifiable risk the only relevant risk?
5–12 What risk does beta measure? How can you find the beta of a portfolio?
5–13 Explain the meaning of each variable in the capital asset pricing model
(CAPM) equation. What is the security market line (SML)?
5–14 What impact would the following changes have on the security market
line and therefore on the required return for a given level of risk? (a) An
increase in inflationary expectations. (b) Investors become less risk-averse.
5–15 Why do financial managers have some difficulty applying CAPM in financial decision making? Generally, what benefit does CAPM provide them?
S U M M A RY
FOCUS ON VALUE
A firm’s risk and expected return directly affect its share price. As we shall see in Chapter 7,
risk and return are the two key determinants of the firm’s value. It is therefore the financial
manager’s responsibility to assess carefully the risk and return of all major decisions in
order to make sure that the expected returns justify the level of risk being introduced.
The way the financial manager can expect to achieve the firm’s goal of increasing its
share price (and thereby benefiting its owners) is to take only those actions that earn returns
at least commensurate with their risk. Clearly, financial managers need to recognize, measure, and evaluate risk–return tradeoffs in order to ensure that their decisions contribute to
the creation of value for owners.
23. A study by Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of
Finance 47 (June 1992), pp. 427–465, raised serious questions about the validity of CAPM. The study failed to find
a significant relationship between the historical betas and historical returns on over 2,000 stocks during 1963–1990.
In other words, it found that the magnitude of a stock’s historical beta had no relationship to the level of its historical return. Although Fama and French’s study continues to receive attention, CAPM has not been abandoned
because its rejection as a historical model fails to discredit its validity as an expectational model. Therefore, in spite
of this challenge, CAPM continues to be viewed as a logical and useful framework—both conceptually and operationally—for linking expected nondiversifiable risk and return.
246
PART 2
Important Financial Concepts
REVIEW OF LEARNING GOALS
Understand the meaning and fundamentals of
risk, return, and risk preferences. Risk is the
chance of loss or, more formally, the variability of
returns. A number of sources of firm-specific and
shareholder-specific risks exists. Return is any cash
distributions plus the change in value expressed as a
percentage of the initial value. Investment returns
vary both over time and between different types of
investments. The equation for the rate of return is
given in Table 5.13. The three basic risk preference
behaviors are risk-averse, risk-indifferent, and riskseeking. Most financial decision makers are riskaverse. They generally prefer less risky alternatives,
and they require higher expected returns as compensation for taking greater risk.
LG1
Describe procedures for assessing and measuring the risk of a single asset. The risk of a single asset is measured in much the same way as the
risk of a portfolio, or collection, of assets. Sensitivity analysis and probability distributions can be
used to assess risk. In addition to the range, the
standard deviation and the coefficient of variation
are statistics that can be used to measure risk quantitatively. The key equations for the expected value
of a return, the standard deviation of a return, and
the coefficient of variation are summarized in
Table 5.13.
LG2
Discuss the measurement of return and standard deviation for a portfolio and the various
types of correlation that can exist between series of
numbers. The return of a portfolio is calculated as
the weighted average of returns on the individual
assets from which it is formed. The equation for
portfolio return is given in Table 5.13. The portfolio standard deviation is found by using the formula for the standard deviation of a single asset.
Correlation—the statistical relationship between
any two series of numbers—can be positive (the
series move in the same direction), negative (the
series move in opposite directions), or uncorrelated
(the series exhibit no discernible relationship). At
the extremes, the series can be perfectly positively
correlated (have a correlation coefficient of 1) or
perfectly negatively correlated (have a correlation
coefficient of 1).
LG3
Understand the risk and return characteristics
of a portfolio in terms of correlation and diversification, and the impact of international assets on
a portfolio. Diversification involves combining
assets with low (less positive and more negative)
correlation to reduce the risk of the portfolio.
Although the return on a two-asset portfolio will lie
between the returns of the two assets held in isolation, the range of risk depends on the correlation
between the two assets. If they are perfectly positively correlated, the portfolio’s risk will be
between the individual asset’s risks. If they are
uncorrelated, the portfolio’s risk will be between
the risk of the most risky asset and an amount less
than the risk of the least risky asset but greater than
zero. If they are negatively correlated, the portfolio’s risk will be between the risk of the most risky
asset and zero. International diversification can be
used to reduce a portfolio’s risk further. With foreign assets come the risk of currency fluctuation
and political risks.
LG4
Review the two types of risk and the derivation and role of beta in measuring the relevant
risk of both an individual security and a portfolio.
The total risk of a security consists of nondiversifiable and diversifiable risk. Nondiversifiable risk is
the only relevant risk; diversifiable risk can be
eliminated through diversification. Nondiversifiable
risk is measured by the beta coefficient, which is a
relative measure of the relationship between an asset’s return and the market return. Beta is derived
by finding the slope of the “characteristic line”
that best explains the historical relationship between the asset’s return and the market return. The
beta of a portfolio is a weighted average of the betas of the individual assets that it includes. The
equations for total risk and the portfolio beta are
given in Table 5.13.
LG5
Explain the capital asset pricing model
(CAPM), its relationship to the security market
line (SML), and shifts in the SML caused by changes
in inflationary expectations and risk aversion. The
capital asset pricing model (CAPM) uses beta to relate an asset’s risk relative to the market to the asset’s required return. The equation for CAPM is
LG6
CHAPTER 5
TABLE 5.13
Risk and Return
247
Summary of Key Definitions and Formulas for Risk and Return
Definitions of variables
bj beta coefficient or index of nondiversifiable risk for asset j
bp portfolio beta
Ct cash received from the asset investment in the time period t 1 to t
CV coefficient of variation
k
expected value of a return
kj return for the jth outcome; return on asset j; required return on asset j
km market return; the return on the market portfolio of assets
kp portfolio return
kt actual, expected, or required rate of return during period t
n number of outcomes considered
Pt price (value) of asset at time t
Pt1 price (value) of asset at time t 1
Prj probability of occurrence of the jth outcome
RF risk-free rate of return
k standard deviation of returns
wj proportion of total portfolio dollar value represented by asset j
Risk and return formulas
Rate of return during period t:
Ct Pt Pt1
kt Pt1
[Eq. 5.1]
Coefficient of variation:
k
CV k
Expected value of a return:
for probabilistic data:
[Eq. 5.4]
Portfolio return:
n
k kj Prj
[Eq. 5.2]
n
kp wj kj
j1
[Eq. 5.5]
j1
general formula:
Total security risk Nondiversifiable risk
Diversifiable risk
n
kj
[Eq. 5.6]
j1
k
n
[Eq. 5.2a]
Standard deviation of return:
for probabilistic data:
n
bp wj bj
(k k
) Pr
j
2
j
[Eq. 5.3]
j1
Capital asset pricing model
(CAPM):
kj RF [bj (km RF)]
general formula:
n
k [Eq. 5.7]
j1
n
k Portfolio beta:
(kj k)2
j1
n1
[Eq. 5.3a]
[Eq. 5.8]
248
PART 2
Important Financial Concepts
given in Table 5.13. The graphical depiction of
CAPM is the security market line (SML), which
shifts over time in response to changing inflationary
expectations and/or changes in investor risk aversion. Changes in inflationary expectations result in
parallel shifts in the SML in direct response to the
SELF-TEST PROBLEMS
LG3
LG4
ST 5–1
magnitude and direction of change. Increasing risk
aversion results in a steepening in the slope of the
SML, and decreasing risk aversion reduces the slope
of the SML. Although it has some shortcomings,
CAPM provides a useful conceptual framework for
evaluating and linking risk and return.
(Solutions in Appendix B)
Portfolio analysis You have been asked for your advice in selecting a portfolio
of assets and have been given the following data:
Expected return
Year
Asset A
Asset B
Asset C
2004
12%
16%
12%
2005
14
14
14
2006
16
12
16
No probabilities have been supplied. You have been told that you can create two
portfolios—one consisting of assets A and B and the other consisting of assets A
and C—by investing equal proportions (50%) in each of the two component
assets.
a. What is the expected return for each asset over the 3-year period?
b. What is the standard deviation for each asset’s return?
c. What is the expected return for each of the two portfolios?
d. How would you characterize the correlations of returns of the two assets
making up each of the two portfolios identified in part c?
e. What is the standard deviation for each portfolio?
f. Which portfolio do you recommend? Why?
LG5
LG6
ST 5–2
Beta and CAPM Currently under consideration is a project with a beta, b, of
1.50. At this time, the risk-free rate of return, RF, is 7%, and the return on the
market portfolio of assets, km, is 10%. The project is actually expected to earn
an annual rate of return of 11%.
a. If the return on the market portfolio were to increase by 10%, what would
you expect to happen to the project’s required return? What if the market
return were to decline by 10%?
b. Use the capital asset pricing model (CAPM) to find the required return on
this investment.
c. On the basis of your calculation in part b, would you recommend this investment? Why or why not?
d. Assume that as a result of investors becoming less risk-averse, the market
return drops by 1% to 9%. What impact would this change have on your
responses in parts b and c?
CHAPTER 5
Risk and Return
249
PROBLEMS
LG1
5–1
Rate of return Douglas Keel, a financial analyst for Orange Industries, wishes to
estimate the rate of return for two similar-risk investments, X and Y. Keel’s
research indicates that the immediate past returns will serve as reasonable estimates of future returns. A year earlier, investment X had a market value of
$20,000, investment Y of $55,000. During the year, investment X generated cash
flow of $1,500 and investment Y generated cash flow of $6,800. The current market values of investments X and Y are $21,000 and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most
recent year’s data.
b. Assuming that the two investments are equally risky, which one should Keel
recommend? Why?
LG1
5–2
Return calculations For each of the investments shown in the following table,
calculate the rate of return earned over the unspecified time period.
Investment
A
B
C
D
E
LG1
5–3
Cash flow
during period
Beginning-ofperiod value
$ 100
15,000
7,000
80
1,500
$
800
120,000
45,000
600
12,500
End-ofperiod value
$ 1,100
118,000
48,000
500
12,400
Risk preferences Sharon Smith, the financial manager for Barnett Corporation,
wishes to evaluate three prospective investments: X, Y, and Z. Currently, the
firm earns 12% on its investments, which have a risk index of 6%. The expected
return and expected risk of the investments are as follows:
Investment
Expected
return
X
Y
Z
14%
12
10
Expected
risk index
7%
8
9
a. If Sharon Smith were risk-indifferent, which investments would she select?
Explain why.
b. If she were risk-averse, which investments would she select? Why?
c. If she were risk-seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?
LG2
5–4
Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating
250
PART 2
Important Financial Concepts
the possible outcomes, the company made the estimates shown in the following
table
Expansion A
Initial investment
Annual rate of return
Pessimistic
Most likely
Optimistic
Expansion B
$12,000
$12,000
16%
20%
24%
10%
20%
30%
a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose?
Why? What does this imply about your feelings toward risk?
d. Assume that expansion B’s most likely outcome is 21% per year and that
all other facts remain the same. Does this change your answer to part c?
Why?
LG2
5–5
Risk and probability Micro-Pub, Inc., is considering the purchase of one of
two microfilm cameras, R and S. Both should provide benefits over a 10-year
period, and each requires an initial investment of $4,000. Management has constructed the following table of estimates of rates of return and probabilities for
pessimistic, most likely, and optimistic results:
Camera R
Camera S
Amount
Probability
Amount
Probability
$4,000
1.00
$4,000
1.00
Pessimistic
20%
.25
15%
.20
Most likely
25%
.50
25%
.55
Optimistic
30%
.25
35%
.25
Initial investment
Annual rate of return
a. Determine the range for the rate of return for each of the two cameras.
b. Determine the expected value of return for each camera.
c. Purchase of which camera is riskier? Why?
LG2
5–6
Bar charts and risk Swan’s Sportswear is considering bringing out a line of
designer jeans. Currently, it is negotiating with two different well-known designers. Because of the highly competitive nature of the industry, the two lines of
jeans have been given code names. After market research, the firm has established the expectations shown in the following table about the annual rates
of return
CHAPTER 5
Risk and Return
251
Annual rate of return
Market acceptance
Probability
Line J
Line K
Very poor
.05
.0075
.010
Poor
.15
.0125
.025
Average
.60
.0850
.080
Good
.15
.1475
.135
Excellent
.05
.1625
.150
Use the table to:
a. Construct a bar chart for each line’s annual rate of return.
b. Calculate the expected value of return for each line.
c. Evaluate the relative riskiness for each jean line’s rate of return using the bar
charts.
LG2
5–7
Coefficient of variation Metal Manufacturing has isolated four alternatives for
meeting its need for increased production capacity. The data gathered relative to
each of these alternatives is summarized in the following table.
Alternative
Expected
return
Standard
deviation of return
A
20%
7.0%
B
22
9.5
C
19
6.0
D
16
5.5
a. Calculate the coefficient of variation for each alternative.
b. If the firm wishes to minimize risk, which alternative do you recommend?
Why?
LG2
5–8
Standard deviation versus coefficient of variation as measures of risk Greengage,
Inc., a successful nursery, is considering several expansion projects. All of the
alternatives promise to produce an acceptable return. The owners are extremely
risk-averse; therefore, they will choose the least risky of the alternatives. Data on
four possible projects follow.
Project
Expected return
Range
Standard deviation
A
12.0%
.040
.029
B
12.5
.050
.032
C
13.0
.060
.035
D
12.8
.045
.030
252
PART 2
Important Financial Concepts
a. Which project is least risky, judging on the basis of range?
b. Which project has the lowest standard deviation? Explain why standard deviation is not an appropriate measure of risk for purposes of this comparison.
c. Calculate the coefficient of variation for each project. Which project will
Greengage’s owners choose? Explain why this may be the best measure of
risk for comparing this set of opportunities.
LG2
5–9
Assessing return and risk Swift Manufacturing must choose between two asset
purchases. The annual rate of return and the related probabilities given in the
following table summarize the firm’s analysis to this point.
Project 257
Project 432
Rate of return
Probability
Rate of return
Probability
10%
10
20
30
40
45
50
60
70
80
100
.01
.04
.05
.10
.15
.30
.15
.10
.05
.04
.01
10%
15
20
25
30
35
40
45
50
.05
.10
.10
.15
.20
.15
.10
.10
.05
a. For each project, compute:
(1) The range of possible rates of return.
(2) The expected value of return.
(3) The standard deviation of the returns.
(4) The coefficient of variation of the returns.
b. Construct a bar chart of each distribution of rates of return.
c. Which project would you consider less risky? Why?
LG2
5–10
Integrative—Expected return, standard deviation, and coefficient of variation
Three assets—F, G, and H—are currently being considered by Perth Industries.
The probability distributions of expected returns for these assets are shown in
the following table.
Asset F
Asset G
Asset H
j
Prj
Return, kj
Prj
Return, kj
Prj
Return, kj
1
2
3
4
5
.10
.20
.40
.20
.10
40%
10
0
5
10
.40
.30
.30
35%
10
20
.10
.20
.40
.20
.10
40%
20
10
0
20
–
a. Calculate the expected value of return, k , for each of the three assets. Which
provides the largest expected return?
CHAPTER 5
Risk and Return
253
b. Calculate the standard deviation, k, for each of the three assets’ returns.
Which appears to have the greatest risk?
c. Calculate the coefficient of variation, CV, for each of the three assets’
returns. Which appears to have the greatest relative risk?
LG2
5–11
Normal probability distribution Assuming that the rates of return associated
with a given asset investment are normally distributed and that the expected
return, k, is 18.9% and the coefficient of variation, CV, is .75, answer the following questions.
a. Find the standard deviation of returns, k.
b. Calculate the range of expected return outcomes associated with the following probabilities of occurrence: (1) 68%, (2) 95%, (3) 99%.
c. Draw the probability distribution associated with your findings in parts a
and b.
LG3
5–12
Portfolio return and standard deviation Jamie Wong is considering building a
portfolio containing two assets, L and M. Asset L will represent 40% of the
dollar value of the portfolio, and asset M will account for the other 60%. The
expected returns over the next 6 years, 2004–2009, for each of these assets, are
shown in the following table.
Expected return
Year
Asset L
Asset M
2004
2005
2006
2007
2008
2009
14%
14
16
17
17
19
20%
18
16
14
12
10
a. Calculate the expected portfolio return, kp, for each of the 6 years.
b. Calculate the expected value of portfolio returns, k
p, over the 6-year period.
c. Calculate the standard deviation of expected portfolio returns, k , over the
p
6-year period.
d. How would you characterize the correlation of returns of the two assets L
and M?
e. Discuss any benefits of diversification achieved through creation of the
portfolio.
LG3
5–13
Portfolio analysis You have been given the return data shown in the first table
on three assets—F, G, and H—over the period 2004–2007.
Expected return
Year
Asset F
Asset G
Asset H
2004
2005
2006
2007
16%
17
18
19
17%
16
15
14
14%
15
16
17
254
PART 2
Important Financial Concepts
Using these assets, you have isolated the three investment alternatives shown in
the following table:
Alternative
Investment
1
100% of asset F
2
50% of asset F and 50% of asset G
3
50% of asset F and 50% of asset H
a. Calculate the expected return over the 4-year period for each of the three
alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each of
the three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for
each of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives do
you recommend? Why?
LG4
5–14
Correlation, risk, and return Matt Peters wishes to evaluate the risk and return
behaviors associated with various combinations of assets V and W under three
assumed degrees of correlation: perfect positive, uncorrelated, and perfect negative. The expected return and risk values calculated for each of the assets are
shown in the following table.
Asset
V
W
Expected
return, k
8%
13
Risk (standard
deviation), k
5%
10
a. If the returns of assets V and W are perfectly positively correlated (correlation coefficient 1), describe the range of (1) expected return and (2) risk
associated with all possible portfolio combinations.
b. If the returns of assets V and W are uncorrelated (correlation coefficient 0),
describe the approximate range of (1) expected return and (2) risk associated
with all possible portfolio combinations.
c. If the returns of assets V and W are perfectly negatively correlated (correlation coefficient 1), describe the range of (1) expected return and (2) risk
associated with all possible portfolio combinations.
LG1
LG4
5–15
International investment returns Joe Martinez, a U.S. citizen living in
Brownsville, Texas, invested in the common stock of Telmex, a Mexican corporation. He purchased 1,000 shares at 20.50 pesos per share. Twelve months
later, he sold them at 24.75 pesos per share. He received no dividends during
that time.
a. What was Joe’s investment return (in percentage terms) for the year, on the
basis of the peso value of the shares?
b. The exchange rate for pesos was 9.21 pesos per $US1.00 at the time of the
purchase. At the time of the sale, the exchange rate was 9.85 pesos per
$US1.00. Translate the purchase and sale prices into $US.
c. Calculate Joe’s investment return on the basis of the $US value of the shares.
CHAPTER 5
Risk and Return
255
d. Explain why the two returns are different. Which one is more important to
Joe? Why?
LG5
5–16
Total, nondiversifiable, and diversifiable risk David Talbot randomly selected
securities from all those listed on the New York Stock Exchange for his portfolio. He began with a single security and added securities one by one until a total
of 20 securities were held in the portfolio. After each security was added, David
calculated the portfolio standard deviation, k . The calculated values are shown
p
in the following table.
Number of
securities
Portfolio
risk, kp
Number of
securities
Portfolio
risk, kp
1
14.50%
11
7.00%
2
13.30
12
6.80
3
12.20
13
6.70
4
11.20
14
6.65
5
10.30
15
6.60
6
9.50
16
6.56
7
8.80
17
6.52
8
8.20
18
6.50
9
7.70
19
6.48
10
7.30
20
6.47
a. On a set of “number of securities in portfolio (x axis)–portfolio risk (y axis)”
axes, plot the portfolio risk data given in the preceding table.
b. Divide the total portfolio risk in the graph into its nondiversifiable and diversifiable risk components and label each of these on the graph.
c. Describe which of the two risk components is the relevant risk, and explain
why it is relevant. How much of this risk exists in David Talbot’s portfolio?
LG5
5–17
Graphical derivation of beta A firm wishes to estimate graphically the betas
for two assets, A and B. It has gathered the return data shown in the following
table for the market portfolio and for both assets over the last ten years,
1994–2003.
Actual return
Year
Market portfolio
Asset A
11%
Asset B
1994
6%
1995
2
8
11
16%
1996
13
4
10
1997
4
3
3
1998
8
0
3
1999
16
19
30
2000
10
14
22
2001
15
18
29
2002
8
12
19
2003
13
17
26
256
PART 2
Important Financial Concepts
a. On a set of “market return (x axis)–asset return (y axis)” axes, use the data
given to draw the characteristic line for asset A and for asset B.
b. Use the characteristic lines from part a to estimate the betas for assets A and B.
c. Use the betas found in part b to comment on the relative risks of assets A and B.
LG5
5–18
Interpreting beta A firm wishes to assess the impact of changes in the market
return on an asset that has a beta of 1.20.
a. If the market return increased by 15%, what impact would this change be
expected to have on the asset’s return?
b. If the market return decreased by 8%, what impact would this change be
expected to have on the asset’s return?
c. If the market return did not change, what impact, if any, would be expected
on the asset’s return?
d. Would this asset be considered more or less risky than the market? Explain.
LG5
5–19
Betas Answer the following questions for assets A to D shown in the following
table.
Asset
Beta
A
.50
B
1.60
C
.20
D
.90
a. What impact would a 10% increase in the market return be expected to have
on each asset’s return?
b. What impact would a 10% decrease in the market return be expected to have
on each asset’s return?
c. If you were certain that the market return would increase in the near future,
which asset would you prefer? Why?
d. If you were certain that the market return would decrease in the near future,
which asset would you prefer? Why?
LG5
5–20
Betas and risk rankings Stock A has a beta of .80, stock B has a beta of 1.40,
and stock C has a beta of .30.
a. Rank these stocks from the most risky to the least risky.
b. If the return on the market portfolio increased by 12%, what change would
you expect in the return for each of the stocks?
c. If the return on the market portfolio decreased by 5%, what change would
you expect in the return for each of the stocks?
d. If you felt that the stock market was just ready to experience a significant
decline, which stock would you probably add to your portfolio? Why?
e. If you anticipated a major stock market rally, which stock would you add to
your portfolio? Why?
LG5
5–21
Portfolio betas Rose Berry is attempting to evaluate two possible portfolios,
which consist of the same five assets held in different proportions. She is particu-
CHAPTER 5
Risk and Return
257
larly interested in using beta to compare the risks of the portfolios, so she has
gathered the data shown in the following table.
Portfolio weights
Asset
Asset beta
1
1.30
10%
30%
2
.70
30
10
3
1.25
10
20
4
1.10
10
20
5
.90
40
100%
20
100%
Totals
Portfolio A
Portfolio B
a. Calculate the betas for portfolios A and B.
b. Compare the risks of these portfolios to the market as well as to each other.
Which portfolio is more risky?
LG6
5–22
Capital asset pricing model (CAPM) For each of the cases shown in the following table, use the capital asset pricing model to find the required return.
Case
LG5
Risk-free
rate, RF
Market
return, km
8%
Beta, b
A
5%
B
8
13
1.30
.90
C
9
12
.20
D
10
15
1.00
E
6
10
.60
LG6
5–23
Beta coefficients and the capital asset pricing model Katherine Wilson is wondering how much risk she must undertake in order to generate an acceptable
return on her portfolio. The risk-free return currently is 5%. The return on the
average stock (market return) is 16%. Use the CAPM to calculate the beta coefficient associated with each of the following portfolio returns.
a. 10%
b. 15%
c. 18%
d. 20%
e. Katherine is risk-averse. What is the highest return she can expect if she is
unwilling to take more than an average risk?
LG6
5–24
Manipulating CAPM Use the basic equation for the capital asset pricing model
(CAPM) to work each of the following problems.
a. Find the required return for an asset with a beta of .90 when the risk-free rate
and market return are 8% and 12%, respectively.
258
PART 2
Important Financial Concepts
b. Find the risk-free rate for a firm with a required return of 15% and a beta of
1.25 when the market return is 14%.
c. Find the market return for an asset with a required return of 16% and a beta
of 1.10 when the risk-free rate is 9%.
d. Find the beta for an asset with a required return of 15% when the risk-free
rate and market return are 10% and 12.5%, respectively.
LG1
LG3
LG5
LG6
5–25
Portfolio return and beta Jamie Peters invested $100,000 to set up the following portfolio one year ago:
Asset
Cost
Beta at purchase
Yearly income
Value today
A
$20,000
.80
$1,600
B
35,000
.95
1,400
36,000
C
30,000
1.50
—
34,500
D
15,000
1.25
375
16,500
$20,000
a. Calculate the portfolio beta on the basis of the original cost figures.
b. Calculate the percentage return of each asset in the portfolio for the year.
c. Calculate the percentage return of the portfolio on the basis of original cost,
using income and gains during the year.
d. At the time Jamie made his investments, investors were estimating that the
market return for the coming year would be 10%. The estimate of the riskfree rate of return averaged 4% for the coming year. Calculate an expected
rate of return for each stock on the basis of its beta and the expectations of
market and risk-free returns.
e. On the basis of the actual results, explain how each stock in the portfolio
performed relative to those CAPM-generated expectations of performance.
What factors could explain these differences?
LG6
5–26
Security market line, SML Assume that the risk-free rate, RF, is currently 9%
and that the market return, km, is currently 13%.
a. Draw the security market line (SML) on a set of “nondiversifiable risk
(x axis)–required return (y axis)” axes.
b. Calculate and label the market risk premium on the axes in part a.
c. Given the previous data, calculate the required return on asset A having a
beta of .80 and asset B having a beta of 1.30.
d. Draw in the betas and required returns from part c for assets A and B on the
axes in part a. Label the risk premium associated with each of these assets,
and discuss them.
LG6
5–27
Shifts in the security market line Assume that the risk-free rate, RF, is currently
8%, the market return, km, is 12%, and asset A has a beta, bA, of 1.10.
a. Draw the security market line (SML) on a set of “nondiversifiable risk
(x axis)–required return (y axis)” axes.
b. Use the CAPM to calculate the required return, kA, on asset A, and depict
asset A’s beta and required return on the SML drawn in part a.
c. Assume that as a result of recent economic events, inflationary expectations
have declined by 2%, lowering RF and km to 6% and 10%, respectively.
CHAPTER 5
Risk and Return
259
Draw the new SML on the axes in part a, and calculate and show the new
required return for asset A.
d. Assume that as a result of recent events, investors have become more riskaverse, causing the market return to rise by 1%, to 13%. Ignoring the shift in
part c, draw the new SML on the same set of axes that you used before, and
calculate and show the new required return for asset A.
e. From the previous changes, what conclusions can be drawn about the impact
of (1) decreased inflationary expectations and (2) increased risk aversion on
the required returns of risky assets?
LG6
5–28
Integrative—Risk, return, and CAPM Wolff Enterprises must consider several
investment projects, A through E, using the capital asset pricing model (CAPM)
and its graphical representation, the security market line (SML). Relevant information is presented in the following table.
Item
Risk-free asset
Rate of return
9%
Beta, b
0
Market portfolio
14
1.00
Project A
—
1.50
Project B
—
.75
Project C
—
2.00
Project D
—
0
Project E
—
.50
a. Calculate the required rate of return and risk premium for each project, given
its level of nondiversifiable risk.
b. Use your findings in part a to draw the security market line (required return
relative to nondiversifiable risk).
c. Discuss the relative nondiversifiable risk of projects A through E.
d. Assume that recent economic events have caused investors to become less
risk-averse, causing the market return to decline by 2%, to 12%. Calculate
the new required returns for assets A through E, and draw the new security
market line on the same set of axes that you used in part b.
e. Compare your findings in parts a and b with those in part d. What conclusion can you draw about the impact of a decline in investor risk aversion on
the required returns of risky assets?
CHAPTER 5 CASE
Analyzing Risk and Return on Chargers Products’ Investments
J
unior Sayou, a financial analyst for Chargers Products, a manufacturer of stadium benches, must evaluate the risk and return of two assets, X and Y. The
firm is considering adding these assets to its diversified asset portfolio. To assess
the return and risk of each asset, Junior gathered data on the annual cash flow
and beginning- and end-of-year values of each asset over the immediately preceding 10 years, 1994–2003. These data are summarized in the accompanying
table. Junior’s investigation suggests that both assets, on average, will tend to
260
PART 2
Important Financial Concepts
Return Data for Assets X and Y, 1994–2003
Asset X
Asset Y
Value
Value
Year
Cash flow
Beginning
Ending
Cash flow
Beginning
Ending
1994
$1,000
$20,000
$22,000
$1,500
$20,000
$20,000
1995
1,500
22,000
21,000
1,600
20,000
20,000
1996
1,400
21,000
24,000
1,700
20,000
21,000
1997
1,700
24,000
22,000
1,800
21,000
21,000
1998
1,900
22,000
23,000
1,900
21,000
22,000
1999
1,600
23,000
26,000
2,000
22,000
23,000
2000
1,700
26,000
25,000
2,100
23,000
23,000
2001
2,000
25,000
24,000
2,200
23,000
24,000
2002
2,100
24,000
27,000
2,300
24,000
25,000
2003
2,200
27,000
30,000
2,400
25,000
25,000
perform in the future just as they have during the past 10 years. He therefore
believes that the expected annual return can be estimated by finding the average
annual return for each asset over the past 10 years.
Junior believes that each asset’s risk can be assessed in two ways: in isolation
and as part of the firm’s diversified portfolio of assets. The risk of the assets in
isolation can be found by using the standard deviation and coefficient of variation of returns over the past 10 years. The capital asset pricing model (CAPM)
can be used to assess the asset’s risk as part of the firm’s portfolio of assets.
Applying some sophisticated quantitative techniques, Junior estimated betas for
assets X and Y of 1.60 and 1.10, respectively. In addition, he found that the riskfree rate is currently 7% and that the market return is 10%.
Required
a. Calculate the annual rate of return for each asset in each of the 10 preceding
years, and use those values to find the average annual return for each asset
over the 10-year period.
b. Use the returns calculated in part a to find (1) the standard deviation and (2)
the coefficient of variation of the returns for each asset over the 10-year
period 1994–2003.
c. Use your findings in parts a and b to evaluate and discuss the return and risk
associated with each asset. Which asset appears to be preferable? Explain.
d. Use the CAPM to find the required return for each asset. Compare this value
with the average annual returns calculated in part a.
e. Compare and contrast your findings in parts c and d. What recommendations
would you give Junior with regard to investing in either of the two assets?
Explain to Junior why he is better off using beta rather than the standard
deviation and coefficient of variation to assess the risk of each asset.
CHAPTER 5
Risk and Return
261
f. Rework parts d and e under each of the following circumstances:
(1) A rise of 1% in inflationary expectations causes the risk-free rate to rise
to 8% and the market return to rise to 11%.
(2) As a result of favorable political events, investors suddenly become less
risk-averse, causing the market return to drop by 1%, to 9%.
WEB EXERCISE
WW
W
Go to the RiskGrades Web site, www.riskgrades.com. This site, from
RiskMetrics Group, provides another way to assess the riskiness of stocks and
mutual funds. RiskGrades provide a way to compare investment risk across all
asset classes, regions, and currencies. They vary over time to reflect asset-specific
information (such as the price of a stock reacting to an earnings release) and general market conditions. RiskGrades operate differently from traditional risk measures, such as standard deviation and beta.
1. First, learn more about RiskGrades by clicking on RiskGrades Help Center
and reviewing the material. How are RiskGrades calculated? What differences can you identify when you compare them to standard deviation and
beta techniques? What are the advantages and disadvantages of this measure, in your opinion?
2. Get RiskGrades for the following stocks using the Get RiskGrade pull-down
menu at the site’s upper right corner. You can enter multiple symbols separated by commas. Select all dates to get a historical view.
Company
Symbol
Citigroup
C
Intel
INTC
Microsoft
MSFT
Washington Mutual
WM
What do the results tell you?
3. Select one of the foregoing stocks and find other stocks with similar risk
grades. Click on By RiskGrade to pull up a list.
4. How much risk can you tolerate? Use a hypothetical portfolio to find out.
Click on Grade Yourself, take a short quiz, and get your personal
RiskGrade measure. Did the results surprise you?
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
CHAPTER
6
INTEREST RATES AND
BOND VALUATION
L E A R N I N G
LG1
Describe interest rate fundamentals, the term
structure of interest rates, and risk premiums.
LG2
Review the legal aspects of bond financing and
bond cost.
LG3
LG4
Discuss the general features, quotations, ratings,
popular types, and international issues of corporate bonds.
LG5
LG6
G O A L S
Apply the basic valuation model to bonds and
describe the impact of required return and time to
maturity on bond values.
Explain yield to maturity (YTM), its calculation,
and the procedure used to value bonds that pay
interest semiannually.
Understand the key inputs and basic model used
in the valuation process.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand interest rates and the
various types of bonds in order to be able to account properly
for amortization of bond premiums and discounts and for bond
purchases and retirements.
Marketing: You need to understand how the interest rate level
and the firm’s ability to issue bonds may affect the availability
of financing for marketing research projects and new-product
development.
Information systems: You need to understand the data that you
will need to track in bond amortization schedules and bond
valuation.
Operations: You need to understand how the interest rate level
may affect the firm’s ability to raise funds to maintain and
increase the firm’s production capacity.
Management: You need to understand the behavior of interest
rates and how they will affect the types of funds the firm can
raise and the timing and cost of bond issues and retirements.
262
FORD
FORD CRUISES
THE DEBT MARKETS
ord and Ford Motor Credit Co. (FMCC), its finance unit, were frequent visitors to the corporate
debt markets in 2001, selling over $22 billion in long-term notes and bonds. Despite the problems in the auto industry, investors nervous about stock market volatility were willing to accept
the credit risk to get higher yields. The company’s 2001 offerings had something for all types of
investors, ranging from 2- to 10-year notes to 30-year bonds. Demand for Ford’s debt was so high
that in January the company increased the size of its issue from $5 billion to $7.8 billion, and October’s plan to issue $3 billion turned into a $9.4 billion offering.
The world’s second largest auto manufacturer joined other corporate bond issuers to take
advantage of strengthening bond markets. Even though the Federal Reserve began cutting shortterm rates, interest rates for the longer maturities remained attractively low for corporations.
Unlike some other auto companies who limited the size of their debt offerings, FMCC decided to
borrow as much as possible to lock in the very wide spread between its lower borrowing costs
and what its auto loans yielded.
All this debt came at a price, however. Both major bond-rating agencies—Moody’s
Investors Service and Standard & Poor’s (S&P)—downgraded Ford’s debt quality ratings in
October 2001. Moody’s lowered Ford’s long-term debt rating by one rating class but did not
change FMCC’s quality rating. Ford spokesman Todd Nissen was pleased that Moody’s confirmed
the FMCC ratings. “It will help us keep our costs of borrowing down, which benefits Ford Credit
and ultimately Ford Motor,” he said. S&P’s outlook for Ford was more negative; the agency cut
ratings on all Ford and FMCC debt one rating class. The lower ratings contributed to the higher
yields on Ford’s October debt. For example, in April FMCC’s 10-year notes yielded 7.1 percent,
about 2 points above U.S. Treasury bonds. In October, 10-year FMCC notes yielded 7.3 percent, or
2.7 points above U.S. Treasury bonds.
For corporations like Ford, deciding when to issue debt and selecting the best maturities
requires knowledge of interest rate fundamentals, risk premiums, issuance costs, ratings, and
similar features of corporate bonds. In this chapter you’ll learn about these important topics and
also become acquainted with techniques for valuing bonds.
F
263
264
PART 2
Important Financial Concepts
LG1
6.1 Interest Rates and Required Returns
As noted in Chapter 1, financial institutions and markets create the mechanism
through which funds flow between savers (funds suppliers) and investors (funds
demanders). The level of funds flow between suppliers and demanders can significantly affect economic growth. Growth results from the interaction of a variety of
economic factors (such as the money supply, trade balances, and economic policies) that affect the cost of money—the interest rate or required return. The interest
rate level acts as a regulating device that controls the flow of funds between suppliers and demanders. The Board of Governors of the Federal Reserve System regularly assesses economic conditions and, when necessary, initiates actions to raise or
lower interest rates to control inflation and economic growth. Generally, the lower
the interest rate, the greater the funds flow and therefore the greater the economic
growth; the higher the interest rate, the lower the funds flow and economic growth.
Interest Rate Fundamentals
interest rate
The compensation paid by the
borrower of funds to the lender;
from the borrower’s point of
view, the cost of borrowing
funds.
required return
The cost of funds obtained by
selling an ownership interest; it
reflects the funds supplier’s level
of expected return.
liquidity preferences
General preferences of investors
for shorter-term securities.
real rate of interest
The rate that creates an equilibrium between the supply of
savings and the demand for
investment funds in a perfect
world, without inflation, where
funds suppliers and demanders
are indifferent to the term of
loans or investments and have no
liquidity preference, and where
all outcomes are certain.
The interest rate or required return represents the cost of money. It is the compensation that a demander of funds must pay a supplier. When funds are lent, the
cost of borrowing the funds is the interest rate. When funds are obtained by selling an ownership interest—as in the sale of stock—the cost to the issuer (demander) is commonly called the required return, which reflects the funds supplier’s
level of expected return. In both cases the supplier is compensated for providing
funds. Ignoring risk factors, the cost of funds results from the real rate of interest
adjusted for inflationary expectations and liquidity preferences—general preferences of investors for shorter-term securities.
The Real Rate of Interest
Assume a perfect world in which there is no inflation and in which funds suppliers
and demanders are indifferent to the term of loans or investments because they
have no liquidity preference and all outcomes are certain.1 At any given point in
time in that perfect world, there would be one cost of money—the real rate of
interest. The real rate of interest creates an equilibrium between the supply of savings and the demand for investment funds. It represents the most basic cost of
money. The real rate of interest in the United States is assumed to be stable and
equal to around 1 percent.2 This supply–demand relationship is shown in Figure
6.1 by the supply function (labeled S0) and the demand function (labeled D). An
equilibrium between the supply of funds and the demand for funds (S0 D)
occurs at a rate of interest k0*, the real rate of interest.
Clearly, the real rate of interest changes with changing economic conditions,
tastes, and preferences. A trade surplus could result in an increased supply of
1. These assumptions are made to describe the most basic interest rate, the real rate of interest. Subsequent discussions relax these assumptions to develop the broader concept of the interest rate and required return.
2. Data in Stocks, Bonds, Bills and Inflation, 2001 Yearbook (Chicago: Ibbotson Associates, Inc., 2001), show that
over the period 1926–2000, U.S. Treasury bills provided an average annual real rate of return of about 0.7 percent.
Because of certain major economic events that occurred during the 1926–2000 period, many economists believe that
the real rate of interest during recent years has been about 1 percent.
CHAPTER 6
Interest Rates and Bond Valuation
265
FIGURE 6.1
D
Real Rate of Interest
Supply–Demand
Relationship
Supply of savings and
demand for investment funds
S0
S1
k*0
k*1
S0
S1
D
S0 = D
S1 = D
Funds Supplied/Demanded
funds, causing the supply function in Figure 6.1 to shift to, say, S1. This could
result in a lower real rate of interest, k1*, at equilibrium (S1 D). Likewise, a
change in tax laws or other factors could affect the demand for funds, causing the
real rate of interest to rise or fall to a new equilibrium level.
Nominal or Actual Rate of Interest (Return)
nominal rate of interest
The actual rate of interest
charged by the supplier of funds
and paid by the demander.
The nominal rate of interest is the actual rate of interest charged by the supplier
of funds and paid by the demander. Throughout this book, interest rates and
required rates of return are nominal rates unless otherwise noted. The nominal
rate of interest differs from the real rate of interest, k*, as a result of two factors:
(1) inflationary expectations reflected in an inflation premium (IP), and (2) issuer
and issue characteristics, such as default risk and contractual provisions, reflected
in a risk premium (RP). When this notation is adopted, the nominal rate of interest for security 1, k1, is given in Equation 6.1:
k1 k* IP RP1
(6.1)
risk-free
risk
rate, RF premium
As the horizontal braces below the equation indicate, the nominal rate, k1, can be
viewed as having two basic components: a risk-free rate of interest, RF, and a risk
premium, RP1:
k1 RF RP1
(6.2)
To simplify the discussion, we will assume that the risk premium, RP1, is
equal to zero. By drawing from Equation 6.1,3 the risk-free rate can (as earlier
noted in Equation 5.9) be represented as
RF k* IP
(6.3)
3. This equation is commonly called the Fisher equation, named for the renowned economist Irving Fisher, who first
presented this approximate relationship between nominal interest and the rate of inflation. See Irving Fisher, The
Theory of Interest (New York: Macmillan, 1930).
266
PART 2
Important Financial Concepts
Thus we concern ourselves only with the risk-free rate of interest, RF, which was
defined in Chapter 5 as the required return on a risk-free asset.4 The risk-free rate
(as shown in Equation 6.3) embodies the real rate of interest plus the inflationary
expectation. Three-month U.S. Treasury bills (T-bills), which are (as noted in
Chapter 5) short-term IOUs issued by the U.S. Treasury, are commonly considered
the risk-free asset. The real rate of interest can be estimated by subtracting the
inflation premium from the nominal rate of interest. For the risk-free asset in Equation 6.3, the real rate of interest, k*, would equal RF IP. A simple example can
demonstrate the practical distinction between nominal and real rates of interest.
EXAMPLE
Marilyn Carbo has $10 that she can spend on candy costing $0.25 per piece. She
could therefore buy 40 pieces of candy ($10.00/$0.25) today. The nominal rate
of interest on a 1-year deposit is currently 7%, and the expected rate of inflation
over the coming year is 4%. Instead of buying the 40 pieces of candy today,
Marilyn could invest the $10 in a 1-year deposit account now. At the end of 1
year she would have $10.70 because she would have earned 7% interest—an
additional $0.70 (0.07 $10.00)—on her $10 deposit. The 4% inflation rate
would over the 1-year period increase the cost of the candy by 4%—an additional $0.01 (0.04 $0.25)—to $0.26 per piece. As a result, at the end of the 1year period Marilyn would be able to buy about 41.2 pieces of candy
($10.70/$0.26), or roughly 3% more (41.2/40.0 1.03). The increase in the
amount of money available to Marilyn at the end of 1 year is merely her nominal
rate of return (7%), which must be reduced by the rate of inflation (4%) during
the period to determine her real rate of return of 3%. Marilyn’s increased buying
power therefore equals her 3% real rate of return.
The premium for inflationary expectations in Equation 6.3 represents the
average rate of inflation expected over the life of a loan or investment. It is not
the rate of inflation experienced over the immediate past; rather, it reflects the
forecasted rate. Take, for example, the risk-free asset. During the week ended
March 15, 2002, 3-month T-bills earned a 1.81 percent rate of return. Assuming
an approximate 1 percent real rate of interest, funds suppliers were forecasting a
0.81 percent (annual) rate of inflation (1.81% 1.00%) over the next 3 months.
This expectation was in striking contrast to the expected rate of inflation 17 years
earlier in the week ending May 22, 1981. At that time the 3-month T-bill rate
was 16.60 percent, which meant an expected (annual) inflation rate of 15.60 percent (16.60% 1.00%). The inflationary expectation premium changes over
time in response to many factors, including recent rates, government policies, and
international events.
Figure 6.2 illustrates the movement of the rate of inflation and the risk-free
rate of interest during the period 1978–2001. During this period the two rates
tended to move in a similar fashion. Between 1978 and the early 1980s, inflation
and interest rates were quite high, peaking at over 13 percent in 1980–1981.
Since 1981 these rates have declined to levels generally below those in 1978. The
data clearly illustrate the significant impact of inflation on the nominal rate of
interest for the risk-free asset.
4. The risk premium and its effect on the nominal rate of interest are discussed and illustrated in a later part of this
discussion.
CHAPTER 6
Interest Rates and Bond Valuation
267
FIGURE 6.2
15
Annual Rate (%)
Impact of Inflation
Relationship between annual
rate of inflation and 3-month
U.S. Treasury bill average
annual returns, 1978–2001
10
T-billsa
5
Inflationb
1978
1983
1988
1993
1998
2001
Year
a Average annual rate of return on 3-month U.S. Treasury bills.
b Annual pecentage change in the consumer price index.
Source: Data from selected Federal Reserve Bulletins.
term structure
of interest rates
The relationship between the
interest rate or rate of return and
the time to maturity.
yield to maturity
Annual rate of return earned on a
debt security purchased on a
given day and held to maturity.
yield curve
A graph of the relationship
between the debt’s remaining
time to maturity (x axis) and its
yield to maturity (y axis); it
shows the pattern of annual
returns on debts of equal quality
and different maturities.
Graphically depicts the term
structure of interest rates.
inverted yield curve
A downward-sloping yield curve
that indicates generally cheaper
long-term borrowing costs than
short-term borrowing costs.
normal yield curve
An upward-sloping yield curve
that indicates generally cheaper
short-term borrowing costs than
long-term borrowing costs.
flat yield curve
A yield curve that reflects
relatively similar borrowing
costs for both short- and longerterm loans.
Term Structure of Interest Rates
For any class of similar-risk securities, the term structure of interest rates relates
the interest rate or rate of return to the time to maturity. For convenience we will
use Treasury securities as an example, but other classes could include securities
that have similar overall quality or risk. The riskless nature of Treasury securities
also provides a laboratory in which to develop the term structure.
Yield Curves
A debt security’s yield to maturity (discussed later in this chapter) represents the
annual rate of return earned on a security purchased on a given day and held to
maturity. At any point in time, the relationship between the debt’s remaining
time to maturity and its yield to maturity is represented by the yield curve. The
yield curve shows the yield to maturity for debts of equal quality and different
maturities; it is a graphical depiction of the term structure of interest rates. Figure 6.3 shows three yield curves for all U.S. Treasury securities: one at May 22,
1981, a second at September 29, 1989, and a third at March 15, 2002. Note
that both the position and the shape of the yield curves change over time. The
yield curve of May 22, 1981, indicates that short-term interest rates at that time
were above longer-term rates. This curve is described as downward-sloping,
reflecting long-term borrowing costs generally cheaper than short-term borrowing costs. Historically, the downward-sloping yield curve, which is often called
an inverted yield curve, has been the exception. More frequently, yield curves
similar to that of March 15, 2002, have existed. These upward-sloping or
normal yield curves indicate that short-term borrowing costs are below longterm borrowing costs. Sometimes, a flat yield curve, similar to that of September
29, 1989, exists. It reflects relatively similar borrowing costs for both short- and
longer-term loans.
PART 2
Important Financial Concepts
FIGURE 6.3
Treasury Yield Curves
Yield curves for U.S. Treasury
securities: May 22, 1981;
September 29, 1989; and
March 15, 2002
Yield (annual rate of interest, %)
268
18
16
May 22, 1981
14
12
10
September 29, 1989
8
6
March 15, 2002
4
2
0
5
10
15
20
25
30
Time of Maturity (years)
Sources: Data from Federal Reserve Bulletins (June 1981), p. A25 and (December 1989), p. A24;
and U.S. Financial Data, Federal Reserve Bank of St. Louis (March 14, 2002), p. 7.
The shape of the yield curve may affect the firm’s financing decisions. A
financial manager who faces a downward-sloping yield curve is likely to rely more
heavily on cheaper, long-term financing; when the yield curve is upward-sloping,
the manager is more likely to use cheaper, short-term financing. Although a variety of other factors also influence the choice of loan maturity, the shape of the
yield curve provides useful insights into future interest rate expectations.
Theories of Term Structure
Three theories are frequently cited to explain the general shape of the yield curve.
They are the expectations theory, liquidity preference theory, and market segmentation theory.
expectations theory
The theory that the yield curve
reflects investor expectations
about future interest rates; an
increasing inflation expectation
results in an upward-sloping
yield curve, and a decreasing
inflation expectation results in a
downward-sloping yield curve
Expectations Theory One theory of the term structure of interest rates, the
expectations theory, suggests that the yield curve reflects investor expectations
about future interest rates and inflation. Higher future rates of expected inflation
will result in higher long-term interest rates; the opposite occurs with lower
future rates. This widely accepted explanation of the term structure can be
applied to the securities of any issuer. For example, take the case of U.S.
Treasury securities. Thus far, we have concerned ourselves solely with the 3month Treasury bill. In fact, all Treasury securities are riskless in terms of (1) the
chance that the Treasury will default on the issue and (2) the ease with which
they can be liquidated for cash without losing value. Because it is believed to be
easier to forecast inflation over shorter periods of time, the shorter-term 3-month
U.S. Treasury bill is considered the risk-free asset. Of course, differing inflation
expectations associated with different maturities will cause nominal interest rates
to vary. With the addition of a maturity subscript, t, Equation 6.3 can be rewritten as
RF k* IPt
t
(6.4)
CHAPTER 6
FOCUS ON PRACTICE
Interest Rates and Bond Valuation
Watch Those Curves!
Why do financial institutions, individual investors, and corporations
that need to issue debt pay close
attention to the yield curve, looking
for any changing patterns? Because the shape of the yield
curve—a chart of the gap between
short- and long-term interest
rates—has been an excellent predictor of future economic growth in
the United States. In general, sharp
upward-sloping (“normal”) yield
curves signal a substantial rise in
economic activity within a year.
Downward-sloping (“inverted”)
yield curves have preceded every
recession since 1955 (although recession did not follow an inverted
curve in the mid-1960s).
The yield curve is based on
the manner in which rates on different debt maturities are set. The
marketplace determines long-term
interest rates, which are tied to
various economic factors, such as
investors’ views on the outlook for
growth and for inflation. Because
the Federal Reserve sets shortterm rates, it can direct the pace of
economic activity by managing the
differences between the two ends
of the interest rate spectrum. Most
periods of flat or inverted yield
curves occur when the Federal Reserve increases short-term rates,
tightening monetary policy to control inflation. These higher rates
curtail business growth because
savers pull money out of long-term
investments such as stocks and
bonds and put it into lower-risk
savings vehicles. When short-term
rates are low, people switch
money from liquid investments
such as money market accounts
into long-term investments, fueling
economic growth.
This proved true in 2001. An
inverted yield curve from July 2000
to early January 2001 triggered the
slowdown in economic activity. In
January the Federal Reserve cut
the federal funds rate (the rate on
loan transactions between commercial banks) to stimulate the
economy but wasn’t able to prevent the recession that began in
March 2001. The Fed cut short-
269
In Practice
term rates 10 more times in 2001—
a record for cuts in one year—to
bring the “fed funds” rate from 6.5
percent to 1.75 percent, the lowest
level since 1961. Long-term U.S.
Treasury securities outperformed
shorter maturities as institutional
and individual investors shifted
their portfolios to longer maturities,
betting that the curve would return
to its more normal upward slope as
the Federal Reserve rate cuts took
effect. By December 2001 the
spread between long-term and
short-term Treasury securities was
about 2.5 points. As the yield curve
turned strongly positive, economists predicted a short recession
with a strong recovery in 2002.
Sources: Adapted from Peronet Despeignes,
“Fed Cuts Rates by Quarter Point to 1.75%,”
FT.com (December 11, 2001), downloaded
from news.ft.com; Michael Sivy, “Ahead of
the Curve,” Money (August 2001), p. 51;
Michael Wallace, “The Fed Can’t Get Ahead
of the Curve,” Business Week Online
(November 5, 2001), downloaded from
www.businessweek.com; Linda Wertheimer,
“Analysis: Federal Reserve’s Latest Interest
Rate Cut,” All Things Considered (NPR),
November 6, 2001, downloaded from Electric
Library, ask.elibrary.com.
In other words, for U.S. Treasury securities the nominal, or risk-free, rate for a
given maturity varies with the inflation expectation over the term of the security.5
EXAMPLE
The nominal interest rate, RF, for four maturities of U.S. Treasury securities on
March 15, 2002, is given in column 1 of the following table. Assuming that the
real rate of interest is 1%, as noted in column 2, the inflation expectation for each
maturity in column 3 is found by solving Equation 6.4 for IPt. Although a 0.81%
rate of inflation was expected over the 3-month period beginning March 15,
2002, a 2.55% average rate of inflation was expected over the 2-year period, and
so on. An analysis of the inflation expectations in column 3 for March 15, 2002,
suggests that at that time a general expectation of increasing inflation existed.
Simply stated, the March 15, 2002, yield curve for U.S. Treasury securities shown
5. Although U.S. Treasury securities have no risk of default or illiquidity, they do suffer from “maturity, or interest
rate, risk”—the risk that interest rates will change in the future and thereby affect longer maturities more than
shorter maturities. Therefore, the longer the maturity of a Treasury (or any other) security, the greater its interest rate
risk. The impact of interest rate changes on bond values is discussed later in this chapter; here we ignore this effect.
270
PART 2
Important Financial Concepts
in Figure 6.3 was upward-sloping as a result of the expectation that the rate of
inflation would increase in the future.6
Maturity, t
Nominal interest
rate, RFt
(1)
Real interest
rate, k*
(2)
Inflation
expectation, IPt
[(1) (2)]
(3)
3 months
1.81%
1.00%
0.81%
2 years
3.55
1.00
2.55
5 years
4.74
1.00
3.74
30 years
5.90
1.00
4.90
Generally, under the expectations theory, an increasing inflation expectation
results in an upward-sloping yield curve; a decreasing inflation expectation results
in a downward-sloping yield curve; and a stable inflation expectation results in a
flat yield curve. Although, as we’ll see, other theories exist, the observed strong
relationship between inflation and interest rates (see Figure 6.2) supports this
widely accepted theory.
liquidity preference theory
Theory suggesting that for any
given issuer, long-term interest
rates tend to be higher than
short-term rates because
(1) lower liquidity and higher
responsiveness to general
interest rate movements of
longer-term securities exists and
(2) borrower willingness to pay a
higher rate for long-term financing; causes the yield curve to be
upward-sloping.
market segmentation theory
Theory suggesting that the
market for loans is segmented on
the basis of maturity and that the
supply of and demand for loans
within each segment determine
its prevailing interest rate; the
slope of the yield curve is
determined by the general
relationship between the prevailing rates in each segment.
Liquidity Preference Theory The tendency for yield curves to be upwardsloping can be further explained by liquidity preference theory. This theory holds
that for a given issuer, such as the U.S. Treasury, long-term rates tend to be
higher than short-term rates. This belief is based on two behavioral facts:
1. Investors perceive less risk in short-term securities than in longer-term securities and are therefore willing to accept lower yields on them. The reason is
that shorter-term securities are more liquid and less responsive to general
interest rate movements.7
2. Borrowers are generally willing to pay a higher rate for long-term than for
short-term financing. By locking in funds for a longer period of time, they
can eliminate the potential adverse consequences of having to roll over shortterm debt at unknown costs to obtain long-term financing.
Investors (lenders) tend to require a premium for tying up funds for longer
periods, whereas borrowers are generally willing to pay a premium to obtain
longer-term financing. These preferences of lenders and borrowers cause the yield
curve to tend to be upward-sloping. Simply stated, longer maturities tend to have
higher interest rates than shorter maturities.
Market Segmentation Theory The market segmentation theory suggests
that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest
rate. In other words, the equilibrium between suppliers and demanders of shortterm funds, such as seasonal business loans, would determine prevailing short-
6. It is interesting to note (in Figure 6.3) that the expectations reflected by the September 29, 1989, yield curve were
not fully borne out by actual events. By March 2002, interest rates had fallen for all maturities, and the yield curve
at that time had shifted downward and become upward-sloping, reflecting an expectation of increasing future interest rates and inflation rates.
7. Later in this chapter we demonstrate that debt instruments with longer maturities are more sensitive to changing
market interest rates. For a given change in market rates, the price or value of longer-term debts will be more significantly changed (up or down) than the price or value of debts with shorter maturities.
CHAPTER 6
Hint An upward-sloping
yield curve will result if the
supply outstrips the demand for
short-term loans, thereby resulting in relatively low shortterm rates at a time when longterm rates are high because the
demand for long-term loans is
far above their supply.
Interest Rates and Bond Valuation
271
term interest rates, and the equilibrium between suppliers and demanders of
long-term funds, such as real estate loans, would determine prevailing long-term
interest rates. The slope of the yield curve would be determined by the general
relationship between the prevailing rates in each market segment. Simply stated,
low rates in the short-term segment and high rates in the long-term segment cause
the yield curve to be upward-sloping. The opposite occurs for high short-term
rates and low long-term rates.
All three theories of term structure have merit. From them we can conclude
that at any time, the slope of the yield curve is affected by (1) inflationary expectations, (2) liquidity preferences, and (3) the comparative equilibrium of supply
and demand in the short- and long-term market segments. Upward-sloping yield
curves result from higher future inflation expectations, lender preferences for
shorter-maturity loans, and greater supply of short-term loans than of long-term
loans relative to demand. The opposite behaviors would result in a downwardsloping yield curve. At any time, the interaction of these three forces determines
the prevailing slope of the yield curve.
Risk Premiums: Issuer and Issue Characteristics
So far we have considered only risk-free U.S. Treasury securities. We now reintroduce the risk premium and assess it in view of risky non-Treasury issues.
Recall Equation 6.1:
k1 k* IP RP1
risk-free
risk
rate, RF premium
In words, the nominal rate of interest for security 1 (k1) is equal to the risk-free
rate, consisting of the real rate of interest (k*) plus the inflation expectation premium (IP) plus the risk premium (RP1). The risk premium varies with specific
issuer and issue characteristics; it causes similar-maturity securities8 to have differing nominal rates of interest.
8
EXAMPLE
The nominal interest rates on a number of classes of long-term securities on
March 15, 2002, were as follows:910
Security
U.S. Treasury bonds (average)
Nominal interest
5.68%
Corporate bonds (by ratings):
High quality (Aaa–Aa)
6.13
Medium quality (A–Baa)
7.14
Speculative (Ba–C)
8.11
Utility bonds (average rating)
6.99
8. To provide for the same risk-free rate of interest, k* IP, it is necessary to assume equal maturities. When we do
so, the inflationary expectations premium, IP, and therefore RF , will be held constant, and the issuer and issue characteristics premium, RP, becomes the key factor differentiating the nominal rates of interest on various securities.
9. These yields were obtained from Mr. Mike Steelman at UBS PaineWebber, La Jolla, CA (March 25, 2002). Note
that bond ratings are explained later in this chapter, on page 278.
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PART 2
Important Financial Concepts
Because the U.S. Treasury bond would represent the risk-free, long-term security,
we can calculate the risk premium of the other securities by subtracting the riskfree rate, 5.68%, from each nominal rate (yield):
Security
Risk premium
Corporate bonds (by ratings):
High quality (Aaa–Aa)
6.13% 5.68% 0.45%
Medium quality (A–Baa)
7.14
5.68
1.46
Speculative (Ba–C)
8.11
5.68
2.43
6.99
5.68
1.31
Utility bonds (average rating)
These risk premiums reflect differing issuer and issue risks. The lower-rated corporate issues (speculative) have a higher risk premium than that of the higherrated corporates (high quality and medium quality), and the utility issue has a
risk premium near that of the medium-quality corporates.
The risk premium consists of a number of issuer- and issue-related components, including interest rate risk, liquidity risk, and tax risk, which were defined
in Table 5.1 on page 215, and the purely debt-specific risks—default risk, maturity risk, and contractual provision risk, briefly defined in Table 6.1. In general,
TABLE 6.1
Debt-Specific Issuer- and Issue-Related Risk
Premium Components
Component
Description
Default risk
The possibility that the issuer of debt will not pay the contractual interest or principal as scheduled. The greater the uncertainty as to the borrower’s ability to meet these payments, the
greater the risk premium. High bond ratings reflect low
default risk, and low bond ratings reflect high default risk.
Maturity risk
The fact that the longer the maturity, the more the value of a
security will change in response to a given change in interest
rates. If interest rates on otherwise similar-risk securities suddenly rise as a result of a change in the money supply, the
prices of long-term bonds will decline by more than the prices
of short-term bonds, and vice versa.a
Contractual provision risk
Conditions that are often included in a debt agreement or a
stock issue. Some of these reduce risk, whereas others may
increase risk. For example, a provision allowing a bond issuer
to retire its bonds prior to their maturity under favorable
terms increases the bond’s risk.
aA
detailed discussion of the effects of interest rates on the price or value of bonds and other fixed-income
securities is presented later in this chapter.
CHAPTER 6
Interest Rates and Bond Valuation
273
the highest risk premiums and therefore the highest returns result from securities
issued by firms with a high risk of default and from long-term maturities that
have unfavorable contractual provisions.
Review Questions
6–1
6–2
6–3
6–4
6–5
LG2
LG3
What is the real rate of interest? Differentiate it from the nominal rate of
interest for the risk-free asset, a 3-month U.S. Treasury bill.
What is the term structure of interest rates, and how is it related to the
yield curve?
For a given class of similar-risk securities, what does each of the following
yield curves reflect about interest rates: (a) downward-sloping; (b) upwardsloping; and (c) flat? Which form has been historically dominant?
Briefly describe the following theories of the general shape of the yield
curve: (a) expectations theory; (b) liquidity preference theory; and (c) market segmentation theory.
List and briefly describe the potential issuer- and issue-related risk components that are embodied in the risk premium. Which are the purely debtspecific risks?
6.2 Corporate Bonds
corporate bond
A long-term debt instrument
indicating that a corporation has
borrowed a certain amount of
money and promises to repay it in
the future under clearly defined
terms.
coupon interest rate
The percentage of a bond’s par
value that will be paid annually,
typically in two equal semiannual payments, as interest.
A corporate bond is a long-term debt instrument indicating that a corporation
has borrowed a certain amount of money and promises to repay it in the future
under clearly defined terms. Most bonds are issued with maturities of 10 to 30
years and with a par value, or face value, of $1,000. The coupon interest rate on
a bond represents the percentage of the bond’s par value that will be paid annually, typically in two equal semiannual payments, as interest. The bondholders,
who are the lenders, are promised the semiannual interest payments and, at
maturity, repayment of the principal amount.
Legal Aspects of Corporate Bonds
Certain legal arrangements are required to protect purchasers of bonds. Bondholders are protected primarily through the indenture and the trustee.
Bond Indenture
bond indenture
A legal document that specifies
both the rights of the bondholders and the duties of the issuing
corporation.
A bond indenture is a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. Included in the indenture are
descriptions of the amount and timing of all interest and principal payments, various standard and restrictive provisions, and, frequently, sinking-fund requirements and security interest provisions.
274
PART 2
Important Financial Concepts
standard debt provisions
Provisions in a bond indenture
specifying certain recordkeeping and general business
practices that the bond issuer
must follow; normally, they do
not place a burden on a
financially sound business.
restrictive covenants
Provisions in a bond indenture
that place operating and
financial constraints on the
borrower.
Standard Provisions The standard debt provisions in the bond indenture
specify certain record-keeping and general business practices that the bond issuer
must follow. Standard debt provisions do not normally place a burden on a
financially sound business.
The borrower commonly must (1) maintain satisfactory accounting records
in accordance with generally accepted accounting principles (GAAP); (2) periodically supply audited financial statements; (3) pay taxes and other liabilities when
due; and (4) maintain all facilities in good working order.
Restrictive Provisions Bond indentures also normally include certain
restrictive covenants, which place operating and financial constraints on the
borrower. These provisions help protect the bondholder against increases in borrower risk. Without them, the borrower could increase the firm’s risk but not
have to pay increased interest to compensate for the increased risk.
The most common restrictive covenants do the following:
1. Require a minimum level of liquidity, to ensure against loan default.
2. Prohibit the sale of accounts receivable to generate cash. Selling receivables
could cause a long-run cash shortage if proceeds were used to meet current
obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a specified level
of fixed assets to guarantee its ability to repay the bonds.
subordination
In a bond indenture, the stipulation that subsequent creditors
agree to wait until all claims of
the senior debt are satisfied.
4. Constrain subsequent borrowing. Additional long-term debt may be prohibited, or additional borrowing may be subordinated to the original loan.
Subordination means that subsequent creditors agree to wait until all claims
of the senior debt are satisfied.
5. Limit the firm’s annual cash dividend payments to a specified percentage or
amount.
Other restrictive covenants are sometimes included in bond indentures.
The violation of any standard or restrictive provision by the borrower gives
the bondholders the right to demand immediate repayment of the debt. Generally, bondholders evaluate any violation to determine whether it jeopardizes the
loan. They may then decide to demand immediate repayment, continue the loan,
or alter the terms of the bond indenture.
sinking-fund requirement
A restrictive provision often
included in a bond indenture,
providing for the systematic
retirement of bonds prior to their
maturity.
Sinking-Fund Requirements Another common restrictive provision is a
sinking-fund requirement. Its objective is to provide for the systematic retirement
of bonds prior to their maturity. To carry out this requirement, the corporation
makes semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace.
Security Interest The bond indenture identifies any collateral pledged
against the bond and specifies how it is to be maintained. The protection of bond
collateral is crucial to guarantee the safety of a bond issue.
CHAPTER 6
Interest Rates and Bond Valuation
275
Trustee
trustee
A paid individual, corporation, or
commercial bank trust department that acts as the third party
to a bond indenture and can take
specified actions on behalf of the
bondholders if the terms of the
indenture are violated.
A trustee is a third party to a bond indenture. The trustee can be an individual,
a corporation, or (most often) a commercial bank trust department. The trustee
is paid to act as a “watchdog” on behalf of the bondholders and can take specified actions on behalf of the bondholders if the terms of the indenture are
violated.
Cost of Bonds to the Issuer
The cost of bond financing is generally greater than the issuer would have to pay
for short-term borrowing. The major factors that affect the cost, which is the rate
of interest paid by the bond issuer, are the bond’s maturity, the size of the offering, the issuer’s risk, and the basic cost of money.
Impact of Bond Maturity on Bond Cost
Generally, as we noted earlier, long-term debt pays higher interest rates than
short-term debt. In a practical sense, the longer the maturity of a bond, the less
accuracy there is in predicting future interest rates, and therefore the greater the
bondholders’ risk of giving up an opportunity to lend money at a higher rate.
In addition, the longer the term, the greater the chance that the issuer might
default.
Impact of Offering Size on Bond Cost
The size of the bond offering also affects the interest cost of borrowing, but in an
inverse manner: Bond flotation and administration costs per dollar borrowed are
likely to decrease with increasing offering size. On the other hand, the risk to the
bondholders may increase, because larger offerings result in greater risk of default.
Impact of Issuer’s Risk
The greater the issuer’s default risk, the higher the interest rate. Some of this risk
can be reduced through inclusion of appropriate restrictive provisions in the
bond indenture. Clearly, bondholders must be compensated with higher returns
for taking greater risk. Frequently, bond buyers rely on bond ratings (discussed
later) to determine the issuer’s overall risk.
Impact of the Cost of Money
The cost of money in the capital market is the basis for determining a bond’s
coupon interest rate. Generally, the rate on U.S. Treasury securities of equal
maturity is used as the lowest-risk cost of money. To that basic rate is added a
risk premium (as described earlier in this chapter) that reflects the factors mentioned above (maturity, offering size, and issuer’s risk).
276
PART 2
Important Financial Concepts
General Features of a Bond Issue
conversion feature
A feature of convertible bonds
that allows bondholders to
change each bond into a stated
number of shares of common
stock.
call feature
A feature included in nearly all
corporate bond issues that gives
the issuer the opportunity to
repurchase bonds at a stated
call price prior to maturity.
call price
The stated price at which a bond
may be repurchased, by use of a
call feature, prior to maturity.
call premium
The amount by which a bond’s
call price exceeds its par value.
stock purchase warrants
Instruments that give their
holders the right to purchase a
certain number of shares of the
issuer’s common stock at a
specified price over a certain
period of time.
Three features sometimes included in a corporate bond issue are a conversion feature, a call feature, and stock purchase warrants. These features provide the
issuer or the purchaser with certain opportunities for replacing or retiring the
bond or supplementing it with some type of equity issue.
Convertible bonds offer a conversion feature that allows bondholders to
change each bond into a stated number of shares of common stock. Bondholders
convert their bonds into stock only when the market price of the stock is such
that conversion will provide a profit for the bondholder. Inclusion of the conversion feature by the issuer lowers the interest cost and provides for automatic conversion of the bonds to stock if future stock prices appreciate noticeably.
The call feature is included in nearly all corporate bond issues. It gives the
issuer the opportunity to repurchase bonds prior to maturity. The call price is the
stated price at which bonds may be repurchased prior to maturity. Sometimes the
call feature can be exercised only during a certain period. As a rule, the call price
exceeds the par value of a bond by an amount equal to 1 year’s interest. For
example, a $1,000 bond with a 10 percent coupon interest rate would be callable
for around $1,100 [$1,000 (10% $1,000)]. The amount by which the call
price exceeds the bond’s par value is commonly referred to as the call premium.
This premium compensates bondholders for having the bond called away from
them; to the issuer, it is the cost of calling the bonds.
The call feature enables an issuer to call an outstanding bond when interest
rates fall and issue a new bond at a lower interest rate. When interest rates rise,
the call privilege will not be exercised, except possibly to meet sinking-fund
requirements. Of course, to sell a callable bond in the first place, the issuer must
pay a higher interest rate than on noncallable bonds of equal risk, to compensate
bondholders for the risk of having the bonds called away from them.
Bonds occasionally have stock purchase warrants attached as “sweeteners”
to make them more attractive to prospective buyers. Stock purchase warrants are
instruments that give their holders the right to purchase a certain number of
shares of the issuer’s common stock at a specified price over a certain period of
time. Their inclusion typically enables the issuer to pay a slightly lower coupon
interest rate than would otherwise be required.
Interpreting Bond Quotations
quotations
Information on bonds, stocks,
and other securities, including
current price data and statistics
on recent price behavior.
The financial manager needs to stay abreast of the market values of the firm’s
outstanding securities, whether they are traded on an organized exchange, over
the counter, or in international markets. Similarly, existing and prospective
investors in the firm’s securities need to monitor the prices of the securities they
own because these prices represent the current value of their investment. Information on bonds, stocks, and other securities is contained in quotations, which
include current price data along with statistics on recent price behavior. Security
price quotations are readily available for actively traded bonds and stocks. The
most up-to-date “quotes” can be obtained electronically, via a personal computer. Price information is available from stockbrokers and is widely published in
news media. Popular sources of daily security price quotations include financial
newspapers, such as the Wall Street Journal and Investor’s Business Daily, and
the business sections of daily general newspapers. Here we focus on bond quotations; stock quotations are reviewed in Chapter 7.
CHAPTER 6
Interest Rates and Bond Valuation
277
FIGURE 6.4
Bond Quotations
Selected bond quotations for
April 22, 2002
IBM
Source: Wall Street Journal, April 23,
2002, p. C14.
Figure 6.4 includes an excerpt from the New York Stock Exchange (NYSE)
bond quotations reported in the April 23, 2002, Wall Street Journal for transactions through the close of trading on Monday, April 22, 2002. We’ll look at the
corporate bond quotation for IBM, which is highlighted in Figure 6.4. The
numbers following the company name—IBM—represent the bond’s coupon interest rate and the year it matures: “7s25” means that the bond has a stated coupon
interest rate of 7 percent and matures sometime in the year 2025. This information
allows investors to differentiate between the various bonds issued by the corporation. Note that on the day of this quote, IBM had four bonds listed. The next column, labeled “Cur Yld.,” gives the bond’s current yield, which is found by dividing
its annual coupon (7%, or 7.000%) by its closing price (100.25), which in this case
turns out to be 7.0 percent (7.000 100.25 0.0698 7.0%).
The “Vol” column indicates the actual number of bonds that traded on the
given day; 10 IBM bonds traded on Monday, April 22, 2002. The final two
columns include price information—the closing price and the net change in closing price from the prior trading day. Although most corporate bonds are issued
with a par, or face, value of $1,000, all bonds are quoted as a percentage of par.
A $1,000-par-value bond quoted at 110.38 is priced at $1,103.80 (110.38% $1,000). Corporate bonds are quoted in dollars and cents. Thus IBM’s closing
price of 100.25 for the day was $1,002.50—that is, 100.25% $1,000. Because
278
PART 2
Important Financial Concepts
a “Net Chg.” of 1.75 is given in the final column, the bond must have closed at
102 or $1,020 (102.00% $1,000) on the prior day. Its price decreased by 1.75,
or $17.50 (1.75% $1,000), on Tuesday, April 22, 2002. Additional information may be included in a bond quotation, but these are the basic elements.
Bond Ratings
Independent agencies such as Moody’s and Standard & Poor’s assess the riskiness
of publicly traded bond issues. These agencies derive the ratings by using financial ratio and cash flow analyses to assess the likely payment of bond interest and
principal. Table 6.2 summarizes these ratings. Normally an inverse relationship
exists between the quality of a bond and the rate of return that it must provide
bondholders: High-quality (high-rated) bonds provide lower returns than lowerquality (low-rated) bonds. This reflects the lender’s risk-return trade-off. When
considering bond financing, the financial manager must be concerned with the
expected ratings of the bond issue, because these ratings affect salability and cost.
Popular Types of Bonds
Bonds can be classified in a variety of ways. Here we break them into traditional
bonds (the basic types that have been around for years) and contemporary bonds
(newer, more innovative types). The traditional types of bonds are summarized in
terms of their key characteristics and priority of lender’s claim in Table 6.3. Note
Hint Note that Moody’s has
9 major ratings; Standard &
Poor’s has 10.
TABLE 6.2
Moody’s and Standard & Poor’s Bond
Ratingsa
Standard
& Poor’s
Moody’s
Interpretation
Aaa
Prime quality
AAA
Aa
High grade
AA
A
Upper medium grade
A
Baa
Medium grade
BBB
Ba
Lower medium grade
BB
or speculative
B
Speculative
Caa
From very speculative
Ca
C
to near or in default
Lowest grade
Interpretation
Bank investment quality
Speculative
B
CCC
CC
C
Income bond
D
In default
aSome
ratings may be modified to show relative standing within a major rating category; for example, Moody’s uses numerical modifiers (1, 2, 3), whereas Standard & Poor’s uses plus () and
minus () signs.
Sources: Moody’s Investors Service, Inc. and Standard & Poor’s Corporation.
CHAPTER 6
TABLE 6.3
Interest Rates and Bond Valuation
279
Characteristics and Priority of Lender’s Claim of Traditional
Types of Bonds
Bond type
Characteristics
Priority of lender’s claim
Debentures
Unsecured bonds that only creditworthy firms
can issue. Convertible bonds are normally
debentures.
Claims are the same as those of any general
creditor. May have other unsecured bonds
subordinated to them.
Subordinated
debentures
Claims are not satisfied until those of the
creditors holding certain (senior) debts have been
fully satisfied.
Claim is that of a general creditor but not as good
as a senior debt claim.
Income bonds
Payment of interest is required only when
earnings are available. Commonly
issued in reorganization of a failing firm.
Claim is that of a general creditor. Are not in
default when interest payments are missed,
because they are contingent only on earnings
being available.
Mortgage bonds
Secured by real estate or buildings.
Claim is on proceeds from sale of mortgaged
assets; if not fully satisfied, the lender becomes a
general creditor.The first-mortgage claim must be
fully satisfied before distribution of proceeds to
second-mortgage holders, and so on. A number
of mortgages can be issued against the same
collateral.
Collateral trust
bonds
Secured by stock and (or) bonds that are owned
by the issuer. Collateral value is generally 25% to
35% greater than bond value.
Claim is on proceeds from stock and (or) bond
collateral; if not fully satisfied, the lender becomes
a general creditor.
Equipment trust
certificates
Used to finance “rolling stock”—airplanes, trucks,
boats, railroad cars. A trustee buys such an asset
with funds raised through the sale of trust certificates and then leases it to the firm, which,
after making the final scheduled lease payment,
receives title to the asset. A type of leasing.
Claim is on proceeds from the sale of the asset; if
proceeds do not satisfy outstanding debt, trust
certificate lenders become general creditors.
Unsecured Bonds
Secured Bonds
debentures
subordinated debentures
income bonds
mortgage bonds
collateral trust bonds
equipment trust certificates
See Table 6.3
zero- (or low-) coupon bonds
junk bonds
floating-rate bonds
extendible notes
putable bonds
See Table 6.4
that the first three types—debentures, subordinated debentures, and income
bonds—are unsecured, whereas the last three—mortgage bonds, collateral trust
bonds, and equipment trust certificates—are secured.
Table 6.4 describes the key characteristics of five contemporary types of
bonds: zero-coupon or low-coupon bonds, junk bonds, floating-rate bonds,
extendible notes, and putable bonds. These bonds can be either unsecured or
secured. Changing capital market conditions and investor preferences have
spurred further innovations in bond financing in recent years and will probably
continue to do so.
International Bond Issues
Companies and governments borrow internationally by issuing bonds in two principal financial markets: the Eurobond market and the foreign bond market. Both
give borrowers the opportunity to obtain large amounts of long-term debt financing quickly, in the currency of their choice and with flexible repayment terms.
280
PART 2
TABLE 6.4
Important Financial Concepts
Characteristics of Contemporary Types of Bonds
Bond type
Characteristicsa
Zero- (or low-)
coupon bonds
Issued with no (zero) or a very low coupon (stated interest) rate and sold at a large discount from par. A
significant portion (or all) of the investor’s return comes from gain in value (i.e., par value minus purchase
price). Generally callable at par value. Because the issuer can annually deduct the current year’s interest
accrual without having to pay the interest until the bond matures (or is called), its cash flow each year is
increased by the amount of the tax shield provided by the interest deduction.
Junk bonds
Debt rated Ba or lower by Moody’s or BB or lower by Standard & Poor’s. Commonly used during the 1980s
by rapidly growing firms to obtain growth capital, most often as a way to finance mergers and takeovers.
High-risk bonds with high yields—often yielding 2% to 3% more than the best-quality corporate debt.
Floating-rate
bonds
Stated interest rate is adjusted periodically within stated limits in response to changes in specified money
market or capital market rates. Popular when future inflation and interest rates are uncertain. Tend to sell
at close to par because of the automatic adjustment to changing market conditions. Some issues provide
for annual redemption at par at the option of the bondholder.
Extendible notes
Short maturities, typically 1 to 5 years, that can be renewed for a similar period at the option of holders.
Similar to a floating-rate bond. An issue might be a series of 3-year renewable notes over a period of
15 years; every 3 years, the notes could be extended for another 3 years, at a new rate competitive with
market interest rates at the time of renewal.
Putable bonds
Bonds that can be redeemed at par (typically, $1,000) at the option of their holder either at specific dates
after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions, such
as being acquired, acquiring another company, or issuing a large amount of additional debt. In return for
its conferring the right to “put the bond” at specified times or when the firm takes certain actions, the
bond’s yield is lower than that of a nonputable bond.
aThe
claims of lenders (i.e., bondholders) against issuers of each of these types of bonds vary, depending on the bonds’ other features. Each of these
bonds can be unsecured or secured.
Eurobond
A bond issued by an international
borrower and sold to investors in
countries with currencies other
than the currency in which the
bond is denominated.
foreign bond
A bond issued in a host country’s
financial market, in the host
country’s currency, by a foreign
borrower.
A Eurobond is issued by an international borrower and sold to investors in
countries with currencies other than the currency in which the bond is denominated. An example is a dollar-denominated bond issued by a U.S. corporation
and sold to Belgian investors. From the founding of the Eurobond market in the
1960s until the mid-1980s, “blue chip” U.S. corporations were the largest single
class of Eurobond issuers. Some of these companies were able to borrow in this
market at interest rates below those the U.S. government paid on Treasury bonds.
As the market matured, issuers became able to choose the currency in which they
borrowed, and European and Japanese borrowers rose to prominence. In more
recent years, the Eurobond market has become much more balanced in terms of
the mix of borrowers, total issue volume, and currency of denomination.
In contrast, a foreign bond is issued in a host country’s financial market, in the
host country’s currency, by a foreign borrower. A Swiss-franc–denominated bond
issued in Switzerland by a U.S. company is an example of a foreign bond. The
three largest foreign-bond markets are Japan, Switzerland, and the United States.
Review Questions
6–6
What are typical maturities, denominations, and interest payments of a
corporate bond? What mechanisms protect bondholders?
CHAPTER 6
Interest Rates and Bond Valuation
281
6–7
Differentiate between standard debt provisions and restrictive covenants
included in a bond indenture. What are the consequences of violation of
them by the bond issuer?
6–8 How is the cost of bond financing typically related to the cost of shortterm borrowing? In addition to a bond’s maturity, what other major factors affect its cost to the issuer?
6–9 What is a conversion feature? A call feature? Stock purchase warrants?
6–10 What information is found in a bond quotation? How are bonds rated,
and why?
6–11 Compare the basic characteristics of Eurobonds and foreign bonds.
LG4
6.3 Valuation Fundamentals
valuation
The process that links risk and
return to determine the worth of
an asset.
Valuation is the process that links risk and return to determine the worth of an
asset. It is a relatively simple process that can be applied to expected streams of
benefits from bonds, stocks, income properties, oil wells, and so on. To determine an asset’s worth at a given point in time, a financial manager uses the timevalue-of-money techniques presented in Chapter 4 and the concepts of risk and
return developed in Chapter 5.
Key Inputs
There are three key inputs to the valuation process: (1) cash flows (returns), (2)
timing, and (3) a measure of risk, which determines the required return. Each is
described below.
Cash Flows (Returns)
The value of any asset depends on the cash flow(s) it is expected to provide over
the ownership period. To have value, an asset does not have to provide an annual
cash flow; it can provide an intermittent cash flow or even a single cash flow over
the period.
EXAMPLE
Celia Sargent, financial analyst for Groton Corporation, a diversified holding
company, wishes to estimate the value of three of its assets: common stock in
Michaels Enterprises, an interest in an oil well, and an original painting by a wellknown artist. Her cash flow estimates for each are as follows:
Stock in Michaels Enterprises Expect to receive cash dividends of $300 per
year indefinitely.
Oil well Expect to receive cash flow of $2,000 at the end of year 1, $4,000 at
the end of year 2, and $10,000 at the end of year 4, when the well is to be sold.
Original painting Expect to be able to sell the painting in 5 years for
$85,000.
With these cash flow estimates, Celia has taken the first step toward placing a
value on each of the assets.
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PART 2
Important Financial Concepts
Timing
In addition to making cash flow estimates, we must know the timing of the cash
flows.10 For example, Celia expects the cash flows of $2,000, $4,000, and
$10,000 for the oil well to occur at the ends of years 1, 2, and 4, respectively. The
combination of the cash flow and its timing fully defines the return expected from
the asset.
Risk and Required Return
Hint The required rate of
return is the result of investors
being risk-averse. In order for
the risk-averse investor to
purchase a given asset, the
investor must expect at least
enough return to compensate
for the asset’s perceived risk.
EXAMPLE
The level of risk associated with a given cash flow can significantly affect its
value. In general, the greater the risk of (or the less certain) a cash flow, the
lower its value. Greater risk can be incorporated into a valuation analysis by
using a higher required return or discount rate. As in the previous chapter, the
higher the risk, the greater the required return, and the lower the risk, the less the
required return.
Let’s return to Celia Sargent’s task of placing a value on Groton Corporation’s
original painting and consider two scenarios.
Scenario 1—Certainty A major art gallery has contracted to buy the painting for $85,000 at the end of 5 years. Because this is considered a certain situation, Celia views this asset as “money in the bank.” She thus would use the
prevailing risk-free rate of 9% as the required return when calculating the
value of the painting.
Scenario 2—High Risk The values of original paintings by this artist have
fluctuated widely over the past 10 years. Although Celia expects to be able to
get $85,000 for the painting, she realizes that its sale price in 5 years could
range between $30,000 and $140,000. Because of the high uncertainty surrounding the painting’s value, Celia believes that a 15% required return is
appropriate.
These two estimates of the appropriate required return illustrate how this
rate captures risk. The often subjective nature of such estimates is also clear.
The Basic Valuation Model
Simply stated, the value of any asset is the present value of all future cash flows it
is expected to provide over the relevant time period. The time period can be any
length, even infinity. The value of an asset is therefore determined by discounting
the expected cash flows back to their present value, using the required return
commensurate with the asset’s risk as the appropriate discount rate. Utilizing the
present value techniques explained in Chapter 4, we can express the value of any
asset at time zero, V0, as
CF1
CF2
CFn
V0 . . . 1
2
(1 k)
(1 k )
(1 k)n
(6.5)
10. Although cash flows can occur at any time during a year, for computational convenience as well as custom, we
will assume they occur at the end of the year unless otherwise noted.
CHAPTER 6
TABLE 6.5
283
Interest Rates and Bond Valuation
Valuation of Groton Corporation’s Assets by Celia Sargent
Asset
Cash flow, CF
Michaels Enterprises stockb
$300/year indefinitely
Valuationa
Appropriate required return
12%
V0 $300 (PVIFA12%,∞)
1
$300 $
2,5
00
0.12
Oil wellc
Original paintingd
Year (t)
CFt
1
2
3
4
$ 2,000
4,000
0
10,000
$85,000 at end of year 5
20%
V0 [$2,000 (PVIF20%,1)]
[$4,000 (PVIF20%,2)]
[$0 (PVIF20%,3)]
[$10,000 (PVIF20%,4)]
[$2,000 (0.833)]
[$4,000 (0.694)]
[$0 (0.579)]
[$10,000 (0.482)]
$1,666 $2,776
$0 $4,820
$9
,2
6
2
15%
V0 $85,000 (PVIF15%,5)
$85,000 (0.497)
$42,245
aBased on PVIF interest factors from Table A–2. If calculated using a calculator, the values of the oil well and original painting would have been
$9,266.98 and $42,260.03, respectively.
bThis is a perpetuity (infinite-lived annuity), and therefore the present value interest factor given in Equation 4.19 is applied.
cThis is a mixed stream of cash flows and therefore requires a number of PVIFs, as noted.
dThis is a single-amount cash flow and therefore requires a single PVIF.
where
V0 value of the asset at time zero
CFt cash flow expected at the end of year t
k appropriate required return (discount rate)
n relevant time period
Using present value interest factor notation, PVIFk,n from Chapter 4, Equation
6.5 can be rewritten as
V0 [CF1 (PVIFk,1)] [CF2 (PVIFk,2)] . . . [CFn (PVIFk,n)]
(6.6)
We can use Equation 6.6 to determine the value of any asset.
EXAMPLE
Celia Sargent used Equation 6.6 to calculate the value of each asset (using present
value interest factors from Table A–2), as shown in Table 6.5. Michaels Enterprises
stock has a value of $2,500, the oil well’s value is $9,262, and the original painting
has a value of $42,245. Note that regardless of the pattern of the expected cash
flow from an asset, the basic valuation equation can be used to determine its value.
Review Questions
6–12 Why is it important for financial managers to understand the valuation
process?
284
PART 2
Important Financial Concepts
6–13 What are the three key inputs to the valuation process?
6–14 Does the valuation process apply only to assets that provide an annual
cash flow? Explain.
6–15 Define and specify the general equation for the value of any asset, V0.
LG5
LG6
6.4 Bond Valuation
The basic valuation equation can be customized for use in valuing specific securities: bonds, common stock, and preferred stock. Bond valuation is described in
this chapter, and valuation of common stock and preferred stock is discussed in
Chapter 7.
Bond Fundamentals
Hint A bondholder receives
two cash flows from a bond if
it is held to maturity—interest
and the bond’s face value. For
valuation purposes, the interest
is an annuity and the face
value is a single payment received at a specified future date.
EXAMPLE
As noted earlier in this chapter, bonds are long-term debt instruments used by
business and government to raise large sums of money, typically from a diverse
group of lenders. Most corporate bonds pay interest semiannually (every 6
months) at a stated coupon interest rate, have an initial maturity of 10 to
30 years, and have a par value, or face value, of $1,000 that must be repaid at
maturity.11
Mills Company, a large defense contractor, on January 1, 2004, issued a 10%
coupon interest rate, 10-year bond with a $1,000 par value that pays interest
semiannually. Investors who buy this bond receive the contractual right to two
cash flows: (1) $100 annual interest (10% coupon interest rate $1,000 par
value) distributed as $50 (1/2 $100) at the end of each 6 months, and (2) the
$1,000 par value at the end of the tenth year.
We will use data for Mills’s bond issue to look at basic bond valuation.
Basic Bond Valuation
The value of a bond is the present value of the payments its issuer is contractually
obligated to make, from the current time until it matures. The basic model for the
value, B0, of a bond is given by Equation 6.7:
B0 I n
M t1
(1 kd)t (1 kd)n 1
I (PVIFAk
d ,n
1
) M (PVIFk
)
d,n
(6.7)
(6.7a)
11. Bonds often have features that allow them to be retired by the issuer prior to maturity; these conversion and call
features were presented earlier in this chapter. For the purpose of the current discussion, these features are ignored.
CHAPTER 6
Interest Rates and Bond Valuation
285
where
B0 value of the bond at time zero
I annual interest paid in dollars12
n number of years to maturity
M par value in dollars
kd required return on a bond
We can calculate bond value using Equation 6.7a and the appropriate financial
tables (A–2 and A–4) or by using a financial calculator.
EXAMPLE
Assuming that interest on the Mills Company bond issue is paid annually and
that the required return is equal to the bond’s coupon interest rate, I $100, kd 10%, M $1,000, and n 10 years.
The computations involved in finding the bond value are depicted graphically on the following time line.
End of Year
Time line for bond
valuation (Mills
Company’s 10%
coupon interest rate,
10-year maturity,
$1,000 par, January 1,
2004, issue paying
annual interest;
required return 10%)
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
$100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $1,000
$ 614.50
386.00
B0 = $1,000.50
Table Use Substituting the values noted above into Equation 6.7a yields
B0 $100 (PVIFA10%,10yrs) $1,000 (PVIF10%,10yrs)
$100 (6.145) $1,000 (0.386)
1,000.50
$614.50 $386.00 $
The bond therefore has a value of approximately $1,000.13
12. The payment of annual rather than semiannual bond interest is assumed throughout the following discussion.
This assumption simplifies the calculations involved, while maintaining the conceptual accuracy of the valuation
procedures presented.
13. Note that a slight rounding error ($0.50) results here from the use of the table factors, which are rounded to the
nearest thousandth.
286
PART 2
Input
10
Important Financial Concepts
Function
N
10
I
100
PMT
Calculator Use Using the Mills Company’s inputs shown at the left, you should
find the bond value to be exactly $1,000. Note that the calculated bond value is
equal to its par value; this will always be the case when the required return is
equal to the coupon interest rate.14
FV
1000
CPT
Bond Value Behavior
PV
Solution
1000
In practice, the value of a bond in the marketplace is rarely equal to its par value.
In bond quotations (see Figure 6.4), the closing prices of bonds often differ from
their par values of 100 (100 percent of par). Some bonds are valued below par
(quoted below 100), and others are valued above par (quoted above 100). A variety of forces in the economy, as well as the passage of time, tend to affect value.
Although these external forces are in no way controlled by bond issuers or
investors, it is useful to understand the impact that required return and time to
maturity have on bond value.
Required Returns and Bond Values
discount
The amount by which a bond
sells at a value that is less than
its par value.
premium
The amount by which a bond
sells at a value that is greater
than its par value.
EXAMPLE
Whenever the required return on a bond differs from the bond’s coupon interest
rate, the bond’s value will differ from its par value. The required return is likely
to differ from the coupon interest rate because either (1) economic conditions
have changed, causing a shift in the basic cost of long-term funds, or (2) the
firm’s risk has changed. Increases in the basic cost of long-term funds or in risk
will raise the required return; decreases in the cost of funds or in risk will lower
the required return.
Regardless of the exact cause, what is important is the relationship between
the required return and the coupon interest rate: When the required return is
greater than the coupon interest rate, the bond value, B0, will be less than its par
value, M. In this case, the bond is said to sell at a discount, which will equal
M B0. When the required return falls below the coupon interest rate, the bond
value will be greater than par. In this situation, the bond is said to sell at a
premium, which will equal B0 M.
The preceding example showed that when the required return equaled the
coupon interest rate, the bond’s value equaled its $1,000 par value. If for the
same bond the required return were to rise or fall, its value would be found as follows (using Equation 6.7a):
Table Use
Required Return 12%
Required Return 8%
B0 $100 (PVIFA12%,10yrs) $1,000
(PVIF12%,10yrs)
$887.00
B0 $100 (PVIFA8%,10yrs) $1,000
(PVIF8%,10yrs)
$1,134.00
14. Note that because bonds pay interest in arrears, the prices at which they are quoted and traded reflect their value
plus any accrued interest. For example, a $1,000 par value, 10% coupon bond paying interest semiannually and
having a calculated value of $900 would pay interest of $50 at the end of each 6-month period. If it is now 3 months
since the beginning of the interest period, three-sixths of the $50 interest, or $25 (i.e., 3/6 $50), would be accrued.
The bond would therefore be quoted at $925—its $900 value plus the $25 in accrued interest. For convenience,
throughout this book, bond values will always be assumed to be calculated at the beginning of the interest period,
thereby avoiding the need to consider accrued interest.
CHAPTER 6
TABLE 6.6
12%
Function
N
Input
10
Function
N
12
I
8
I
100
PMT
100
PMT
1000
FV
1000
FV
CPT
CPT
PV
PV
Solution
887.00
Solution
1134.20
Bond value, B0
Status
$ 887.00
Discount
10
1,000.00
Par value
8
1,134.00
Premium
Calculator Use Using the inputs shown at the left for the two
different required returns, you will find the value of the bond
to be below or above par. At a 12% required return, the bond
would sell at a discount of $113.00 ($1,000 par value $887.00 value). At the 8% required return, the bond would sell
for a premium of about $134.00 ($1,134.00 value $1,000
par value). The results of this and earlier calculations for Mills
Company’s bond values are summarized in Table 6.6 and
graphically depicted in Figure 6.5. The inverse relationship
between bond value and required return is clearly shown in the
figure.
FIGURE 6.5
1,400
Market Value of Bond, B0 ($)
Bond Values and
Required Returns
Bond values and required
returns (Mills Company’s
10% coupon interest rate,
10-year maturity, $1,000 par,
January 1, 2004, issue paying
annual interest)
1,300
1,200
Premium
Par
Discount
287
Bond Values for Various
Required Returns (Mills
Company’s 10% Coupon
Interest Rate, 10-Year
Maturity, $1,000 Par,
January 1, 2004, Issue
Paying Annual Interest)
Required return, kd
Input
10
Interest Rates and Bond Valuation
1,134
1,100
1,000
900
887
800
700
0
2
4
6
8
10
12
Required Return, kd (%)
14
16
288
PART 2
Important Financial Concepts
Time to Maturity and Bond Values
Whenever the required return is different from the coupon interest rate, the
amount of time to maturity affects bond value. An additional factor is whether
required returns are constant or changing over the life of the bond.
Constant Required Returns When the required return is different from the
coupon interest rate and is assumed to be constant until maturity, the value of the
bond will approach its par value as the passage of time moves the bond’s value
closer to maturity. (Of course, when the required return equals the coupon interest rate, the bond’s value will remain at par until it matures.)
EXAMPLE
interest rate risk
The chance that interest rates
will change and thereby change
the required return and bond
value. Rising rates, which result
in decreasing bond values, are of
greatest concern.
Figure 6.6 depicts the behavior of the bond values calculated earlier and presented in Table 6.6 for Mills Company’s 10% coupon interest rate bond paying
annual interest and having 10 years to maturity. Each of the three required
returns—12%, 10%, and 8%—is assumed to remain constant over the 10 years
to the bond’s maturity. The bond’s value at both 12% and 8% approaches and
ultimately equals the bond’s $1,000 par value at its maturity, as the discount (at
12%) or premium (at 8%) declines with the passage of time.
Changing Required Returns The chance that interest rates will change and
thereby change the required return and bond value is called interest rate risk.
(This was described as a shareholder-specific risk in Chapter 5, Table 5.1.) Bondholders are typically more concerned with rising interest rates because a rise in
interest rates, and therefore in the required return, causes a decrease in bond
value. The shorter the amount of time until a bond’s maturity, the less responsive
Time to Maturity
and Bond Values
Relationship among time to
maturity, required returns,
and bond values (Mills
Company’s 10% coupon interest rate, 10-year maturity,
$1,000 par, January 1, 2004,
issue paying annual interest)
Market Value of Bond, B0 ($)
FIGURE 6.6
Premium Bond, Required Return, kd = 8%
1,200
1,134
1,115
1,100
1,052
1,000
Par-Value Bond, Required Return, kd = 10%
M
952
901
887
Discount Bond, Required Return, kd = 12%
800
10
9
8
7
6
5
4
3
2
Time to Maturity (years)
1
0
CHAPTER 6
FOCUS ON PRACTICE
Interest Rates and Bond Valuation
In Practice
The Value of a Zero
Many investors buy bonds to get a
steady stream of interest payments. So why would anyone buy a
zero-coupon bond, which doesn’t
offer that stream of cash flows?
One reason is the cost of “zeros.”
Because they pay no interest, zeros sell at a deep discount from par
value: A $1,000, 30-year government agency zero-coupon bond
might cost about $175. At maturity,
the investor receives the $1,000 par
value. The difference between the
price of the bond and its par value
is the return to the investor. Stated
as an annual yield, the return reflects the compounding of interest,
just as though the issuer had paid
interest during bond term. In this
example, the bond yields 6 percent.
Even though a corporate issuer of a zero-coupon bond makes
no cash interest payments, for tax
purposes it can take an interest
deduction. To calculate the annual
implicit interest expense, the issuer must first determine the
bond’s value at the beginning of
289
each year by using the formula
M /(1 kd)n, where M the par
value in dollars, kd the required
return, and n the number of
years to maturity. The difference in
the bond’s value from year to year
is the implicit interest.
Assume that a corporation
issues a 5-year zero-coupon bond
with a $1,000 par value and a required yield of 6.5 percent. Applying the above formula, we discover
that the initial price of this bond is
$729.88 [$1,000/(1 0.065)5 $1,000/1.3700867]. Total implicit
interest over the 5 years is $270.12
($1,000 – $729.88). The following
table uses the formula to calculate
the bond’s value at the end of each
year and the implicit interest expense that the corporation can
deduct each year.
Sources: Adapted from Hope Hamashige,
“More than Zero,” Los Angeles Times
(September 16, 1997), p. D-6; Donald Jay
Korn, “Getting Something for Nothing,”
Black Enterprise (April 2000), downloaded
from www.findarticles.com; “Putting Compound Interest to Work Through Zero
Coupon Bonds,” The Bond Market Association, PR Newswire (June 24, 1998), downloaded from www.ask.elibrary.com.
Year
Beginning
value
Ending
value
1
2
3
4
5
$729.88
777.32
827.84
881.66
938.97
$ 777.32
827.84
881.66
938.97
1,000.00
Implicit
Interest Expense
$ 47.44
50.52
53.82
57.31
61.03
Total $270.12
is its market value to a given change in the required return. In other words, short
maturities have less interest rate risk than long maturities when all other features
(coupon interest rate, par value, and interest payment frequency) are the same.
This is because of the mathematics of time value; the present values of short-term
cash flows change far less than the present values of longer-term cash flows in
response to a given change in the discount rate (required return).
EXAMPLE
The effect of changing required returns on bonds of differing maturity can be
illustrated by using Mills Company’s bond and Figure 6.6. If the required return
rises from 10% to 12% (see the dashed line at 8 years), the bond’s value
decreases from $1,000 to $901—a 9.9% decrease. If the same change in required
return had occurred with only 3 years to maturity (see the dashed line at 3 years),
the bond’s value would have dropped to just $952—only a 4.8% decrease. Similar types of responses can be seen for the change in bond value associated with
decreases in required returns. The shorter the time to maturity, the less the impact
on bond value caused by a given change in the required return.
290
PART 2
Important Financial Concepts
Yield to Maturity (YTM)
yield to maturity (YTM)
The rate of return that investors
earn if they buy a bond at a
specific price and hold it until
maturity. (Assumes that the
issuer makes all scheduled
interest and principal payments
as promised.)
EXAMPLE
When investors evaluate bonds, they commonly consider yield to maturity
(YTM). This is the rate of return that investors earn if they buy the bond at a specific price and hold it until maturity. (The measure assumes, of course, that the
issuer makes all scheduled interest and principal payments as promised.) The
yield to maturity on a bond with a current price equal to its par value (that is,
B0 M) will always equal the coupon interest rate. When the bond value differs
from par, the yield to maturity will differ from the coupon interest rate.
Assuming that interest is paid annually, the yield to maturity on a bond can
be found by solving Equation 6.7 for kd. In other words, the current value, the
annual interest, the par value, and the years to maturity are known, and the
required return must be found. The required return is the bond’s yield to maturity. The YTM can be found by trial and error or by use of a financial calculator.
The calculator provides accurate YTM values with minimum effort.
The Mills Company bond, which currently sells for $1,080, has a 10% coupon
interest rate and $1,000 par value, pays interest annually, and has 10 years to
maturity. Because B0 $1,080, I $100 (0.10 $1,000), M $1,000, and
n 10 years, substituting into Equation 6.7a yields
$1,080 $100 (PVIFAk
)
d,10yrs
$1,000 (PVIFk
)
d,10yrs
Our objective is to solve the equation for kd, the YTM.
Trial and Error Because we know that a required return, kd, of 10% (which
equals the bond’s 10% coupon interest rate) would result in a value of $1,000,
the discount rate that would result in $1,080 must be less than 10%. (Remember
that the lower the discount rate, the higher the present value, and the higher the
discount rate, the lower the present value.) Trying 9%, we get
$100 (PVIFA9%,10yrs) $1,000 (PVIF9%,10yrs)
$100 (6.418) $1,000 (0.422)
$641.80 $422.00
$1,063.80
Because the 9% rate is not quite low enough to bring the value up to $1,080, we
next try 8% and get
$100 (PVIFA8%,10yrs) $1,000 (PVIF8%,10yrs)
$100 (6.710) $1,000 (0.463)
$671.00 $463.00
$1,134.00
Because the value at the 8% rate is higher than $1,080 and the value at the 9%
rate is lower than $1,080, the bond’s yield to maturity must be between 8% and
CHAPTER 6
Input
10
9%. Because the $1,063.80 is closer to $1,080, the YTM to the nearest whole
percent is 9%. (By using interpolation, we could eventually find the more precise
YTM value to be 8.77%.)15
Function
N
1080
PV
100
PMT
1000
291
Interest Rates and Bond Valuation
Calculator Use [Note: Most calculators require either the present value (B0 in
this case) or the future values (I and M in this case) to be input as negative numbers to calculate yield to maturity. That approach is employed here.] Using the
inputs shown at the left, you should find the YTM to be 8.766%.
FV
CPT
I
Solution
8.766
Semiannual Interest and Bond Values
The procedure used to value bonds paying interest semiannually is similar to that
shown in Chapter 4 for compounding interest more frequently than annually,
except that here we need to find present value instead of future value. It involves
1. Converting annual interest, I, to semiannual interest by dividing I by 2.
2. Converting the number of years to maturity, n, to the number of 6-month
periods to maturity by multiplying n by 2.
3. Converting the required stated (rather than effective)16 annual return for
similar-risk bonds that also pay semiannual interest from an annual rate, kd,
to a semiannual rate by dividing kd by 2.
Substituting these three changes into Equation 6.7 yields
I
B0 2
WW
W
2n
1
kd t
i1
1 2
1
M kd 2n
1 2
(6.8)17
15. For information on how to interpolate to get a more precise answer, see the book’s home page at www.aw.com/
gitman
16. As we noted in Chapter 4, the effective annual rate of interest, EAR, for stated interest rate i, when interest is
paid semiannually (m 2), can be found by using Equation 4.23:
i
EAR 1 2
2
1
For example, a bond with a 12% required stated return, kd , that pays semiannual interest would have an effective
annual rate of
0.12 2
1 (1.06)2 1 1.1236 1 0.1236 12
.3
6
%
2
EAR 1 Because most bonds pay semiannual interest at semiannual rates equal to 50% of the stated annual rate, their effective annual rates are generally higher than their stated annual rates.
17. Although it may appear inappropriate to use the semiannual discounting procedure on the maturity value, M,
this technique is necessary to find the correct bond value. One way to confirm the accuracy of this approach is to
calculate the bond value for the case where the required stated annual return and coupon interest rate are equal; for
B0 to equal M, as would be expected in such a case, the maturity value must be discounted on a semiannual basis.
292
PART 2
Important Financial Concepts
I
(PVIFAkd/2,2n) M (PVIFkd/2,2n)
2
EXAMPLE
(6.8a)
Assuming that the Mills Company bond pays interest semiannually and that the
required stated annual return, kd, is 12% for similar-risk bonds that also pay
semiannual interest, substituting these values into Equation 6.8a yields
$100
B0 (PVIFA12%/2,210yrs) $1,000 (PVIF12%/2,210yrs)
2
Table Use
B0 $50 (PVIFA6%,20periods) $1,000 (PVIF6%,20periods)
Input
20
Function
N
6
I
50
PMT
1000
FV
CPT
PV
Solution
885.30
885.50
$50 (11.470) $1,000 (0.312) $
Calculator Use In using a calculator to find bond value when interest is paid
semiannually, we must double the number of periods and divide both the
required stated annual return and the annual interest by 2. For the Mills Company bond, we would use 20 periods (2 10 years), a required return of 6%
(12% 2), and an interest payment of $50 ($100 2). Using these inputs, you
should find the bond value with semiannual interest to be $885.30, as shown at
the left. Note that this value is more precise than the value calculated using the
rounded financial-table factors.
Comparing this result with the $887.00 value found earlier for annual compounding (see Table 6.6), we can see that the bond’s value is lower when semiannual interest is paid. This will always occur when the bond sells at a discount. For
bonds selling at a premium, the opposite will occur: The value with semiannual
interest will be greater than with annual interest.
Review Questions
6–16 What basic procedure is used to value a bond that pays annual interest?
Semiannual interest?
6–17 What relationship between the required return and the coupon interest
rate will cause a bond to sell at a discount? At a premium? At its par
value?
6–18 If the required return on a bond differs from its coupon interest rate,
describe the behavior of the bond value over time as the bond moves
toward maturity.
6–19 As a risk-averse investor, would you prefer bonds with short or long periods until maturity? Why?
6–20 What is a bond’s yield to maturity (YTM)? Briefly describe both the trialand-error approach and the use of a financial calculator for finding YTM.
CHAPTER 6
Interest Rates and Bond Valuation
293
S U M M A RY
FOCUS ON VALUE
Interest rates and required returns embody the real cost of money, inflationary expectations, and issuer and issue risk. They reflect the level of return required by market participants as compensation for the risk perceived in a specific security or asset investment.
Because these returns are affected by economic expectations, they vary as a function of
time, typically rising for longer-term maturities or transactions. The yield curve reflects such
market expectations at any point in time.
The value of an asset can be found by calculating the present value of its expected cash
flows, using the required return as the discount rate. Bonds are the easiest financial assets to
value, because both the amounts and the timing of their cash flows are contractual and
therefore known with certainty. The financial manager needs to understand how to apply
valuation techniques to bonds, stocks, and tangible assets (as will be demonstrated in the
following chapters) in order to make decisions that are consistent with the firm’s share price
maximization goal.
REVIEW OF LEARNING GOALS
Describe interest rate fundamentals, the term
structure of interest rates, and risk premiums.
The flow of funds between savers (suppliers) and
investors (demanders) is regulated by the interest
rate or required return. In a perfect, inflation-free,
certain world there would be one cost of money—
the real rate of interest. The nominal or actual interest rate is the sum of the risk-free rate, which is the
sum of the real rate of interest and the inflationary
expectation premium, and a risk premium reflecting
issuer and issue characteristics. For any class of
similar-risk securities, the term structure of interest
rates reflects the relationship between the interest
rate, or rate of return, and the time to maturity.
Yield curves can be downward-sloping (inverted),
upward-sloping (normal), or flat. Three theories—
expectations theory, liquidity preference theory, and
market segmentation theory—are cited to explain
the general shape of the yield curve. Risk premiums
for non-Treasury debt issues result from interest
rate risk, liquidity risk, tax risk, default risk, maturity risk, and contractual provision risk.
LG1
LG2
Review the legal aspects of bond financing and
bond cost. Corporate bonds are long-term debt
instruments indicating that a corporation has borrowed an amount that it promises to repay in the
future under clearly defined terms. Most bonds are
issued with maturities of 10 to 30 years and a par
value of $1,000. The bond indenture, enforced by a
trustee, states all conditions of the bond issue. It
contains both standard debt provisions and restrictive covenants, which may include a sinking-fund
requirement and/or a security interest. The cost of
bonds to an issuer depends on its maturity, offering
size, and issuer risk and on the basic cost of money.
Discuss the general features, quotations, ratings,
popular types, and international issues of corporate bonds. A bond issue may include a conversion
feature, a call feature, or stock purchase warrants.
Bond quotations, published regularly in the financial press, provide information on bonds, including
current price data and statistics on recent price behavior. Bond ratings by independent agencies indicate the risk of a bond issue. Various types of traditional and contemporary bonds are available.
Eurobonds and foreign bonds enable established
creditworthy companies and governments to borrow large amounts internationally.
LG3
294
PART 2
Important Financial Concepts
Understand the key inputs and basic model
used in the valuation process. Key inputs to the
valuation process include cash flows (returns), timing, and risk and the required return. The value of
any asset is equal to the present value of all future
cash flows it is expected to provide over the relevant
time period. The basic valuation formula for any
asset is summarized in Table 6.7.
LG4
Apply the basic valuation model to bonds and
describe the impact of required return and time
to maturity on bond values. The value of a bond is
the present value of its interest payments plus the
present value of its par value. The basic valuation
model for a bond is summarized in Table 6.7. The
discount rate used to determine bond value is the required return, which may differ from the bond’s
coupon interest rate. A bond can sell at a discount,
at par, or at a premium, depending on whether the
required return is greater than, equal to, or less than
its coupon interest rate. The amount of time to maturity affects bond values. Even if the required return remains constant, the value of a bond will approach its par value as the bond moves closer to
maturity. The chance that interest rates will change
and thereby change the required return and bond
LG5
SELF-TEST PROBLEMS
LG5
value is called interest rate risk. The shorter the
amount of time until a bond’s maturity, the less responsive is its market value to a given change in the
required return.
Explain yield to maturity (YTM), its calculation, and the procedure used to value bonds
that pay interest semiannually. Yield to maturity
(YTM) is the rate of return investors earn if they
buy a bond at a specific price and hold it until maturity. YTM can be calculated by trial and error or
financial calculator. Bonds that pay interest semiannually are valued by using the same procedure used
to value bonds paying annual interest, except that
the interest payments are one-half of the annual interest payments, the number of periods is twice the
number of years to maturity, and the required return is one-half of the stated annual required return
on similar-risk bonds.
LG6
(Solutions in Appendix B)
LG6
ST 6–1
Bond valuation Lahey Industries has outstanding a $1,000 par-value bond
with an 8% coupon interest rate. The bond has 12 years remaining to its maturity date.
a. If interest is paid annually, find the value of the bond when the required
return is (1) 7%, (2) 8%, and (3) 10%?
b. Indicate for each case in part a whether the bond is selling at a discount, at a
premium, or at its par value.
c. Using the 10% required return, find the bond’s value when interest is paid
semiannually.
LG6
ST 6–2
Yield to maturity Elliot Enterprises’ bonds currently sell for $1,150, have an
11% coupon interest rate and a $1,000 par value, pay interest annually, and
have 18 years to maturity.
a. Calculate the bonds’ yield to maturity (YTM).
b. Compare the YTM calculated in part a to the bonds’ coupon interest rate,
and use a comparison of the bonds’ current price and their par value to
explain this difference.
CHAPTER 6
TABLE 6.7
Interest Rates and Bond Valuation
295
Summary of Key Valuation Definitions
and Formulas for Any Asset and for Bonds
Definitions of variables
B0 bond value
CFt cash flow expected at the end of year t
I annual interest on a bond
k appropriate required return (discount rate)
kd required return on a bond
M par, or face, value of a bond
n relevant time period, or number of years to maturity
V0 value of the asset at time zero
Valuation formulas
Value of any asset:
CF1
CF2
CFn
. . . V0 (1 k)1
(1 k)2
(1 k)n
[Eq. 6.5]
[CF1 (PVIFk,1)] [CF2 (PVIFk,2)] . . . [CFn (PVIFk,n )]
[Eq. 6.6]
Bond value:
B0 I n
M (1 k ) (1 k )
t1
1
1
d
t
d
I (PVIFAkd ,n) M (PVIFkd ,n)
n
[Eq. 6.7]
[Eq. 6.7a]
PROBLEMS
LG1
6–1
Interest rate fundamentals: The real rate of return Carl Foster, a trainee at an
investment banking firm, is trying to get an idea of what real rate of return
investors are expecting in today’s marketplace. He has looked up the rate paid on
3-month U.S. Treasury bills and found it to be 5.5%. He has decided to use the
rate of change in the Consumer Price Index as a proxy for the inflationary expectations of investors. That annualized rate now stands at 3%. On the basis of the
information that Carl has collected, what estimate can he make of the real rate of
return?
LG1
6–2
Real rate of interest To estimate the real rate of interest, the economics division
of Mountain Banks—a major bank holding company—has gathered the data
summarized in the following table. Because there is a high likelihood that new
tax legislation will be passed in the near future, current data as well as data
reflecting the probable impact of passage of the legislation on the demand for
funds are also included in the table. (Note: The proposed legislation will not
have any impact on the supply schedule of funds. Assume a perfect world in
which inflation is expected to be zero, funds suppliers and demanders have no
liquidity preference, and all outcomes are certain.)
296
PART 2
Important Financial Concepts
With passage
of tax legislation
Currently
Amount of funds
supplied/demanded
($ billion)
Interest rate
required by
funds suppliers
Interest rate
required by
funds demanders
Interest rate
required by
funds demanders
$ 1
2%
7%
9%
5
3
6
8
10
4
4
7
20
6
3
6
50
7
2
4
100
9
1
3
a. Draw the supply curve and the demand curve for funds using the current data.
(Note: Unlike the functions in Figure 6.1, the functions here will not appear
as straight lines.)
b. Using your graph, label and note the real rate of interest using current data.
c. Add to the graph drawn in part a the new demand curve expected in the
event that the proposed tax legislation becomes effective.
d. What is the new real rate of interest? Compare and analyze this finding in
light of your analysis in part b.
LG1
6–3
Real and nominal rates interest Zane Perelli currently has $100 that he can
spend today on polo shirts costing $25 each. Instead he could invest the $100 in
a risk-free U.S. Treasury security that is expected to earn a 9% nominal rate of
interest. The consensus forecast of leading economists is a 5% rate of inflation
over the coming year.
a. How many polo shirts can Zane purchase today?
b. How much money will Zane have at the end of 1 year if he forgoes purchasing the polo shirts today?
c. How much would you expect the polo shirts to cost at the end of 1 year in
light of the expected inflation?
d. Use your findings in parts b and c to determine how many polo shirts
(fractions are OK) Zane can purchase at the end of 1 year. In percentage
terms, how many more or fewer polo shirts can Zane buy at the end of 1
year?
e. What is Zane’s real rate of return over the year? How is it related to the percentage change in Zane’s buying power found in part d? Explain.
LG1
6–4
Yield curve A firm wishing to evaluate interest rate behavior has gathered yield
data on five U.S. Treasury securities, each having a different maturity and all
measured at the same point in time. The summarized data follow.
U.S. Treasury security
Time to maturity
Yield
A
1 year
12.6%
B
10 years
11.2
C
6 months
13.0
D
20 years
11.0
E
5 years
11.4
CHAPTER 6
Interest Rates and Bond Valuation
297
a. Draw the yield curve associated with these data.
b. Describe the resulting yield curve in part a, and explain the general expectations embodied in it.
LG1
6–5
Nominal interest rates and yield curves A recent study of inflationary expectations has revealed that the consensus among economic forecasters yields the following average annual rates of inflation expected over the periods noted. (Note:
Assume that the risk that future interest rate movements will affect longer maturities more than shorter maturities is zero; that is, there is no maturity risk.)
Period
Average annual rate of inflation
3 months
5%
2 years
6
5 years
8
10 years
8.5
20 years
9
a. If the real rate of interest is currently 2.5%, find the nominal interest rate
on each of the following U.S. Treasury issues: 20-year bond, 3-month bill,
2-year note, and 5-year bond.
b. If the real rate of interest suddenly dropped to 2% without any change in
inflationary expectations, what effect, if any, would this have on your
answers in part a? Explain.
c. Using your findings in part a, draw a yield curve for U.S. Treasury securities.
Describe the general shape and expectations reflected by the curve.
d. What would a follower of the liquidity preference theory say about how the
preferences of lenders and borrowers tend to affect the shape of the yield curve
drawn in part c? Illustrate that effect by placing on your graph a dotted line
that approximates the yield curve without the effect of liquidity preference.
e. What would a follower of the market segmentation theory say about the supply and demand for long-term loans versus the supply and demand for shortterm loans given the yield curve constructed for part c of this problem?
LG1
6–6
Nominal and real rates and yield curves A firm wishing to evaluate interest
rate behavior has gathered data on nominal rate of interest and on inflationary
expectation for five U.S. Treasury securities, each having a different maturity
and each measured at a different point in time during the year just ended. (Note:
Assume that the risk that future interest rate movements will affect longer maturities more than shorter maturities is zero; that is, there is no maturity risk.)
These data are summarized in the following table.
U.S. Treasury
security
Point in time
Maturity
Nominal rate
of interest
2 years
12.6%
Inflationary
expectation
A
Jan. 7
B
Mar. 12
C
May 30
D
Aug. 15
20 years
11.0
8.1
E
Dec. 30
5 years
11.4
8.3
10 years
6 months
9.5%
11.2
8.2
13.0
10.0
298
PART 2
Important Financial Concepts
a. Using the preceding data, find the real rate of interest at each point in time.
b. Describe the behavior of the real rate of interest over the year. What forces
might be responsible for such behavior?
c. Draw the yield curve associated with these data, assuming that the nominal
rates were measured at the same point in time.
d. Describe the resulting yield curve in part c, and explain the general expectations embodied in it.
LG1
6–7
Term structure of interest rates The following yield data for a number of highest quality corporate bonds existed at each of the three points in time noted.
Yield
Time to maturity (years)
5 years ago
2 years ago
Today
1
9.1%
14.6%
9.3%
3
9.2
12.8
9.8
5
9.3
12.2
10.9
10
9.5
10.9
12.6
15
9.4
10.7
12.7
20
9.3
10.5
12.9
30
9.4
10.5
13.5
a. On the same set of axes, draw the yield curve at each of the three given times.
b. Label each curve in part a with its general shape (downward-sloping,
upward-sloping, flat).
c. Describe the general inflationary and interest rate expectation existing at
each of the three times.
LG1
6–8
Risk-free rate and risk premiums The real rate of interest is currently 3%; the
inflation expectation and risk premiums for a number of securities follow.
Security
Inflation expectation
premium
Risk premium
A
6%
3%
B
9
2
C
8
2
D
5
4
E
11
1
a. Find the risk-free rate of interest, RF , that is applicable to each security.
b. Although not noted, what factor must be the cause of the differing risk-free
rates found in part a?
c. Find the nominal rate of interest for each security.
LG1
6–9
Risk premiums Eleanor Burns is attempting to find the nominal rate of interest
for each of two securities—A and B—issued by different firms at the same point
in time. She has gathered the following data:
CHAPTER 6
Interest Rates and Bond Valuation
Characteristic
Security A
Security B
Time to maturity
3 years
15 years
Inflation expectation premium
9.0%
7.0%
Liquidity risk
1.0%
1.0%
Default risk
1.0%
2.0%
299
Risk premium for:
Maturity risk
0.5%
1.5%
Other risk
0.5%
1.5%
a. If the real rate of interest is currently 2%, find the risk-free rate of interest
applicable to each security.
b. Find the total risk premium attributable to each security’s issuer and issue
characteristics.
c. Calculate the nominal rate of interest for each security. Compare and discuss
your findings.
LG2
6–10
Bond interest payments before and after taxes Charter Corp. has issued 2,500
debentures with a total principal value of $2,500,000. The bonds have a coupon
interest rate of 7%.
a. What dollar amount of interest per bond can an investor expect to receive
each year from Charter Corp.?
b. What is Charter’s total interest expense per year associated with this bond
issue?
c. Assuming that Charter is in a 35% corporate tax bracket, what is the company’s net after-tax interest cost associated with this bond issue?
LG3
6–11
Bond quotation Assume that the following quote for the Financial Management Corporation’s $1,000-par-value bond was found in the Wednesday,
November 8, issue of the Wall Street Journal.
Fin Mgmt 8.75 05
8.7
558
100.25
0.63
Given this information, answer the following questions.
a. On what day did the trading activity occur?
b. At what price did the bond close at the end of the day on November 7?
c. In what year does the bond mature?
d. How many bonds were traded on the day quoted?
e. What is the bond’s coupon interest rate?
f. What is the bond’s current yield? Explain how this value was calculated.
g. How much of a change, if any, in the bond’s closing price took place between
the day quoted and the day before? At what price did the bond close on the
day before?
LG4
6–12
Valuation fundamentals Imagine that you are trying to evaluate the economics
of purchasing an automobile. You expect the car to provide annual after-tax
cash benefits of $1,200 at the end of each year, and assume that you can sell the
car for after-tax proceeds of $5,000 at the end of the planned 5-year ownership
period. All funds for purchasing the car will be drawn from your savings, which
are currently earning 6% after taxes.
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PART 2
Important Financial Concepts
a. Identify the cash flows, their timing, and the required return applicable to
valuing the car.
b. What is the maximum price you would be willing to pay to acquire the car?
Explain.
LG4
6–13
Valuation of assets Using the information provided in the following table, find
the value of each asset.
Cash flow
Asset
End of year
Amount
Appropriate required return
A
1
$ 5,000
18%
2
5,000
3
5,000
B
1 through ∞
$
300
15%
C
1
$
0
16%
D
E
2
0
3
0
4
0
5
35,000
1 through 5
$ 1,500
6
8,500
1
$ 2,000
2
3,000
3
5,000
4
7,000
5
4,000
6
1,000
12%
14%
LG4
6–14
Asset valuation and risk Laura Drake wishes to estimate the value of an
asset expected to provide cash inflows of $3,000 per year at the end of years 1
through 4 and $15,000 at the end of year 5. Her research indicates that she must
earn 10% on low-risk assets, 15% on average-risk assets, and 22% on high-risk
assets.
a. Determine what is the most Laura should pay for the asset if it is classified as
(1) low-risk, (2) average-risk, and (3) high-risk.
b. Say Laura is unable to assess the risk of the asset and wants to be certain
she’s making a good deal. On the basis of your findings in part a, what is the
most she should pay? Why?
c. All else being the same, what effect does increasing risk have on the value of
an asset? Explain in light of your findings in part a.
LG5
6–15
Basic bond valuation Complex Systems has an outstanding issue of $1,000par-value bonds with a 12% coupon interest rate. The issue pays interest annually and has 16 years remaining to its maturity date.
a. If bonds of similar risk are currently earning a 10% rate of return, how much
should the Complex Systems bond sell for today?
CHAPTER 6
Interest Rates and Bond Valuation
301
b. Describe the two possible reasons why similar-risk bonds are currently earning a return below the coupon interest rate on the Complex Systems bond.
c. If the required return were at 12% instead of 10%, what would the current
value of Complex Systems’ bond be? Contrast this finding with your findings
in part a and discuss.
LG5
6–16
Bond valuation—Annual interest Calculate the value of each of the bonds
shown in the following table, all of which pay interest annually.
Bond
Par value
Coupon interest rate
Years to maturity
Required return
A
$1,000
14%
20
12%
B
1,000
8
16
8
C
100
10
8
13
D
500
16
13
18
E
1,000
12
10
10
LG5
6–17
Bond value and changing required returns Midland Utilities has outstanding a
bond issue that will mature to its $1,000 par value in 12 years. The bond has a
coupon interest rate of 11% and pays interest annually.
a. Find the value of the bond if the required return is (1) 11%, (2) 15%, and
(3) 8%.
b. Plot your findings in part a on a set of “required return (x axis)–market value
of bond (y axis)” axes.
c. Use your findings in parts a and b to discuss the relationship between the
coupon interest rate on a bond and the required return and the market value
of the bond relative to its par value.
d. What two possible reasons could cause the required return to differ from the
coupon interest rate?
LG5
6–18
Bond value and time—Constant required returns Pecos Manufacturing has just
issued a 15-year, 12% coupon interest rate, $1,000-par bond that pays interest
annually. The required return is currently 14%, and the company is certain it
will remain at 14% until the bond matures in 15 years.
a. Assuming that the required return does remain at 14% until maturity, find
the value of the bond with (1) 15 years, (2) 12 years, (3) 9 years, (4) 6 years,
(5) 3 years, and (6) 1 year to maturity.
b. Plot your findings on a set of “time to maturity (x axis)–market value of
bond (y axis)” axes constructed similarly to Figure 6.6.
c. All else remaining the same, when the required return differs from the coupon
interest rate and is assumed to be constant to maturity, what happens to the
bond value as time moves toward maturity? Explain in light of the graph in
part b.
LG5
6–19
Bond value and time—Changing required returns Lynn Parsons is considering
investing in either of two outstanding bonds. The bonds both have $1,000 par
values and 11% coupon interest rates and pay annual interest. Bond A has
exactly 5 years to maturity, and bond B has 15 years to maturity.
302
PART 2
Important Financial Concepts
a. Calculate the value of bond A if the required return is (1) 8%, (2) 11%, and
(3) 14%.
b. Calculate the value of bond B if the required return is (1) 8%, (2) 11%, and
(3) 14%.
c. From your findings in parts a and b, complete the following table, and discuss the relationship between time to maturity and changing required returns.
Required return
Value of bond A
Value of bond B
?
?
11
8%
?
?
14
?
?
d. If Lynn wanted to minimize interest rate risk, which bond should she purchase? Why?
LG6
6–20
Yield to maturity The relationship between a bond’s yield to maturity and
coupon interest rate can be used to predict its pricing level. For each of the
bonds listed, state whether the price of the bond will be at a premium to par, at
par, or at a discount to par.
Bond
Coupon interest rate
Yield to maturity
Price
10%
A
6%
B
8
8
C
9
7
D
7
9
E
12
10
LG6
6–21
Yield to maturity The Salem Company bond currently sells for $955, has a
12% coupon interest rate and a $1,000 par value, pays interest annually, and
has 15 years to maturity.
a. Calculate the yield to maturity (YTM) on this bond.
b. Explain the relationship that exists between the coupon interest rate and yield
to maturity and the par value and market value of a bond.
LG6
6–22
Yield to maturity Each of the bonds shown in the following table pays interest
annually.
Bond
Par value
Coupon interest rate
A
$1,000
B
1,000
12
C
500
12
12
560
D
1,000
15
10
1,120
E
1,000
5
3
900
9%
Years to maturity
Current value
8
$ 820
16
1,000
CHAPTER 6
Interest Rates and Bond Valuation
303
a. Calculate the yield to maturity (YTM) for each bond.
b. What relationship exists between the coupon interest rate and yield to maturity and the par value and market value of a bond? Explain.
LG2
LG5
LG6
6–23
Bond valuation and yield to maturity Mark Goldsmith’s broker has shown
him two bonds. Each has a maturity of 5 years, a par value of $1,000, and a
yield to maturity of 12%. Bond A has a coupon interest rate of 6% paid annually. Bond B has a coupon interest rate of 14% paid annually.
a. Calculate the selling price for each of the bonds.
b. Mark has $20,000 to invest. Judging on the basis of the price of the bonds,
how many of either one could Mark purchase if he were to choose it over the
other? (Mark cannot really purchase a fraction of a bond, but for purposes of
this question, pretend that he can.)
c. Calculate the yearly interest income of each bond on the basis of its
coupon rate and the number of bonds that Mark could buy with his
$20,000.
d. Assume that Mark will reinvest the interest payments as they are paid (at
the end of each year) and that his rate of return on the reinvestment is
only 10%. For each bond, calculate the value of the principal payment
plus the value of Mark’s reinvestment account at the end of the
5 years.
e. Why are the two values calculated in part d different? If Mark were
worried that he would earn less than the 12% yield to maturity on the
reinvested interest payments, which of these two bonds would be a better
choice?
LG6
6–24
Bond valuation—Semiannual interest Find the value of a bond maturing in 6
years, with a $1,000 par value and a coupon interest rate of 10% (5% paid
semiannually) if the required return on similar-risk bonds is 14% annual interest
(7% paid semiannually).
LG6
6–25
Bond valuation—Semiannual interest Calculate the value of each of the bonds
shown in the following table, all of which pay interest semiannually.
LG6
6–26
Bond
Par value
Coupon
interest rate
Years to
maturity
A
$1,000
10%
12
B
1,000
12
20
Required stated
annual return
8%
12
C
500
12
5
14
D
1,000
14
10
10
E
100
6
4
14
Bond valuation—Quarterly interest Calculate the value of a $5,000-par-value
bond paying quarterly interest at an annual coupon interest rate of 10% and
having 10 years until maturity if the required return on similar-risk bonds is currently a 12% annual rate paid quarterly.
304
PART 2
Important Financial Concepts
CHAPTER 6 CASE
Evaluating Annie Hegg’s Proposed Investment
in Atilier Industries Bonds
A
nnie Hegg has been considering investing in the bonds of Atilier Industries.
The bonds were issued 5 years ago at their $1,000 par value and have
exactly 25 years remaining until they mature. They have an 8% coupon interest
rate, are convertible into 50 shares of common stock, and can be called any time
at $1,080. The bond is rated Aa by Moody’s. Atilier Industries, a manufacturer
of sporting goods, recently acquired a small athletic-wear company that was in
financial distress. As a result of the acquisition, Moody’s and other rating agencies are considering a rating change for Atilier bonds. Recent economic data
suggest that inflation, currently at 5% annually, is likely to increase to a 6%
annual rate.
Annie remains interested in the Atilier bond but is concerned about inflation, a potential rating change, and maturity risk. In order to get a feel for the
potential impact of these factors on the bond value, she decided to apply the valuation techniques she learned in her finance course.
Required
a. If price of the the common stock into which the bond is convertible rises to
$30 per share after 5 years and the issuer calls the bonds at $1,080, should
Annie let the bond be called away from her or should she convert it into common stock?
b. For each of the following required returns, calculate the bond’s value, assuming annual interest. Indicate whether the bond will sell at a discount, at a premium, or at par value.
(1) Required return is 6%.
(2) Required return is 8%.
(3) Required return is 10%.
c. Repeat the calculations in part b, assuming that interest is paid semiannually
and that the semiannual required returns are one-half of those shown. Compare and discuss differences between the bond values for each required return
calculated here and in part b under the annual versus semiannual payment
assumptions.
d. If Annie strongly believes that inflation will rise by 1% during the next 6
months, what is the most she should pay for the bond, assuming annual
interest?
e. If the Atilier bonds are downrated by Moody’s from Aa to A, and if such a
rating change will result in an increase in the required return from 8% to
8.75%, what impact will this have on the bond value, assuming annual
interest?
f. If Annie buys the bond today at its $1,000 par value and holds it for exactly
3 years, at which time the required return is 7%, how much of a gain or loss
will she experience in the value of the bond (ignoring interest already received
and assuming annual interest)?
g. Rework part f, assuming that Annie holds the bond for 10 years and sells it
when the required return is 7%. Compare your finding to that in part f, and
comment on the bond’s maturity risk.
CHAPTER 6
Interest Rates and Bond Valuation
305
h. Assume that Annie buys the bond at its current closing price of 98.38 and
holds it until maturity. What will her yield to maturity (YTM) be, assuming
annual interest?
i. After evaluating all of the issues raised above, what recommendation would
you give Annie with regard to her proposed investment in the Atilier Industries bonds?
WEB EXERCISE
WW
W
Go to the Web site www.smartmoney.com. Click on Economy & Bonds. Then
click on Bond Calculator, which is located down the page under the column
Bond Tools. Read the instructions on how to use the bond calculator. Using the
bond calculator:
1. Calculate the yield to maturity (YTM) for a bond whose coupon rate is
7.5% with maturity date of July 31, 2030, which you bought for 95.
2. What is the YTM of the above bond if you bought it for 105? For 100?
3. Change the yield % box to 8.5. What would be the price of this bond?
4. Change the yield % box to 9.5. What is this bond’s price?
5. Change the maturity date to 2006 and reset yield % to 6.5. What is the price
of this bond?
6. Why is the price of the bond in Question 5 higher than the price of the bond
in Question 4?
7. Explore the other bond-related resources at the site. Using Bond Market
Update, comment on current interest rate levels and the yield curve.
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
CHAPTER
7
STOCK
VALUATION
L E A R N I N G
LG1
LG2
LG3
LG4
Differentiate between debt and equity capital.
G O A L S
LG5
Discuss the rights, characteristics, and features
of both common and preferred stock.
Describe the process of issuing common stock,
including in your discussion venture capital, going
public, the investment banker’s role, and stock
quotations.
LG6
Discuss the free cash flow valuation model and
the use of book value, liquidation value, and
price/earnings (P/E) multiples to estimate common stock values.
Explain the relationships among financial decisions, return, risk, and the firm’s value.
Understand the concept of market efficiency and
basic common stock valuation under each of
three cases: zero growth, constant growth, and
variable growth.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand the difference between
debt and equity in terms of tax treatment; the ownership claims
of capital providers, including venture capitalists and stockholders; and why book value per share is not a sophisticated
basis for common stock valuation.
Information systems: You need to understand the procedures
used to issue common stock; the sources and types of information that impact stock value; and how such information can be
used in stock valuation models to link proposed actions to
share price.
Management: You need to understand the difference
between debt and equity capital; the rights and claims of
stockholders; the process of raising funds from venture capi-
306
talists and through initial public offerings; and how the market
will use various stock valuation models to value the firm’s
common stock.
Marketing: You need to understand that the firm’s ideas for
products and services will greatly affect the willingness of venture capitalists and stockholders to contribute capital to the
firm and also that a perceived increase in risk as a result of
new projects may negatively affect the firm’s stock value.
Operations: You need to understand that the amount of capital
the firm has to invest in plant assets and inventory will depend
on the evaluations of venture capitalists and would-be
investors; the better the prospects look for growth, the more
money the firm will have for operations.
OAKLEY
OAKLEY SEES ITS
WAY TO HIGHER VALUE
eople who wanted to buy a pair of
high-fashion Oakley sunglasses in fall
2001 were out of luck if they looked for
them at Sunglass Hut. In August 2001,
Oakley’s biggest distributor announced it
would no longer carry the brand. The
loss of about 25 percent of its sales revenue immediately sent Oakley’s share price down 33 percent to about $12 a share, less than half its 52-week high of $26.56.
Interestingly, however, some analysts considered Oakley stock a good buy despite this significant loss of future earnings. They liked Oakley’s diversification strategy. Trading on the NYSE
under the eyeglass-evoking symbol OO, Oakley is known for its innovative approach to eyewear
design. Its products have international appeal to athletes—from skiers and surfers to golfers and
motorcyclists—and to nonathletes who just like the brand’s trendy looks. To counter the loss of
Sunglass Hut, Oakley added Foot Locker and Champs athletic apparel stores to its distribution
channels. Expanded product lines include other high-performance athletic gear, such as apparel,
footwear, accessories, and prescription eyewear. Company executives are also creative; CEO Jim
Jannard conducted the firm’s annual meeting wearing an Oakley specialty product—the Medusa,
a leather helmet with mirrored goggles and braided strands. Wall Street watchers hoped that
Oakley’s iconoclastic style would take the company to new heights, even without Sunglass Hut.
Using the price-earnings (P/E) multiple approach to estimate the firm’s share value, analysts calculated the share value would be $23.44 (analysts’ average estimated 2002 earnings of
$0.80 a share times the recreational-products industry P/E of 29.3 on December 14, 2001). Said
Eric Beder, an analyst at Ladenburg, Thallmann, “If Oakley can grow at 20 percent a year without
Sunglass Hut, then this stock is worth double what it is now [August 2001] because this company
is just touching the tip of the iceberg with its product lines.”
The new products, retail outlets, and a 20 percent increase in international sales boosted
Oakley’s third-quarter 2001 sales to record levels. In mid-December 2001, Oakley and Sunglass
Hut signed a 3-year agreement to resume their business relationship. With the more optimistic
earnings picture, by late March 2002 the stock valuation increased to $31.19 (analysts’ average
estimated 2003 earnings of $0.97 a share multiplied by a P/E for the recreational products industry
on March 27, 2002, of 32.15), which was considerably above the $17.90 level at which the stock
had been trading.
Stock valuation requires models that bring together cash flows (returns), timing, and the
required return (risk). In this chapter we will examine the differences between debt and equity
capital, describe the characteristics of common and preferred stock, and use several different
valuation models to determine the value of common stock.
P
307
308
PART 2
Important Financial Concepts
LG1
7.1 Differences Between Debt and Equity Capital
capital
The long-term funds of a firm; all
items on the right-hand side of
the firm’s balance sheet, excluding current liabilities.
debt capital
All long-term borrowing incurred
by a firm, including bonds.
equity capital
The long-term funds provided by
the firm’s owners, the stockholders.
The term capital denotes the long-term funds of a firm. All items on the righthand side of the firm’s balance sheet, excluding current liabilities, are sources of
capital. Debt capital includes all long-term borrowing incurred by a firm, including bonds, which were discussed in Chapter 6. Equity capital consists of longterm funds provided by the firm’s owners, the stockholders. A firm can obtain
equity capital either internally, by retaining earnings rather than paying them out
as dividends to its stockholders, or externally, by selling common or preferred
stock. The key differences between debt and equity capital are summarized in
Table 7.1 and discussed below.
Voice in Management
Unlike creditors (lenders), holders of equity capital (common and preferred
stockholders) are owners of the firm. Holders of common stock have voting
rights that permit them to select the firm’s directors and to vote on special issues.
In contrast, debtholders and preferred stockholders may receive voting privileges
only when the firm has violated its stated contractual obligations to them.
Claims on Income and Assets
Holders of equity have claims on both income and assets that are secondary to
the claims of creditors. Their claims on income cannot be paid until the claims of
all creditors (including both interest and scheduled principal payments) have
been satisfied. After satisfying these claims, the firm’s board of directors decides
whether to distribute dividends to the owners.
The equity holders’ claims on assets also are secondary to the claims of creditors. If the firm fails, its assets are sold, and the proceeds are distributed in this
order: employees and customers, the government, creditors, and (finally) equity
holders. Because equity holders are the last to receive any distribution of assets,
they expect greater returns from dividends and/or increases in stock price.
TABLE 7.1
Key Differences Between Debt and
Equity Capital
Type of capital
Characteristic
Debt
Equity
Voice in management a
No
Claims on income and assets
Senior to equity
Subordinate to debt
Maturity
Stated
None
Tax treatment
Interest deduction
No deduction
aIn
Yes
the event that the issuer violates its stated contractual obligations to them, debtholders and preferred stockholders may receive a voice in management; otherwise, only common stockholders have voting rights.
CHAPTER 7
Stock Valuation
309
As is explained in Chapter 11, the costs of equity financing are generally
higher than debt costs. One reason is that the suppliers of equity capital take
more risk because of their subordinate claims on income and assets. Despite
being more costly, equity capital is necessary for a firm to grow. All corporations
must initially be financed with some common stock equity.
Maturity
Unlike debt, equity capital is a permanent form of financing for the firm. It does
not “mature” so repayment is not required. Because equity is liquidated only during bankruptcy proceedings, stockholders must recognize that although a ready
market may exist for their shares, the price that can be realized may fluctuate.
This fluctuation of the market price of equity makes the overall returns to a firm’s
stockholders even more risky.
Tax Treatment
Interest payments to debtholders are treated as tax-deductible expenses by the
issuing firm, whereas dividend payments to a firm’s common and preferred stockholders are not tax-deductible. The tax deductibility of interest lowers the cost of
debt financing, further causing it to be lower than the cost of equity financing.
Review Question
7–1
LG2
LG3
What are the key differences between debt capital and equity capital?
7.2 Common and Preferred Stock
A firm can obtain equity, or ownership, capital by selling either common or preferred stock. All corporations initially issue common stock to raise equity capital.
Some of these firms later issue either additional common stock or preferred stock
to raise more equity capital. Although both common and preferred stock are
forms of equity capital, preferred stock has some similarities to debt capital that
significantly differentiate it from common stock. Here we first consider the key
features and behaviors of both common and preferred stock and then describe
the process of issuing common stock, including the use of venture capital.
Common Stock
The true owners of business firms are the common stockholders. Common stockholders are sometimes referred to as residual owners because they receive what is
left—the residual—after all other claims on the firm’s income and assets have
been satisfied. They are assured of only one thing: that they cannot lose any more
than they have invested in the firm. As a result of this generally uncertain position, common stockholders expect to be compensated with adequate dividends
and, ultimately, capital gains.
310
PART 2
Important Financial Concepts
Ownership
privately owned (stock)
All common stock of a firm
owned by a single individual.
closely owned (stock)
All common stock of a firm
owned by a small group of
investors (such as a family).
publicly owned (stock)
Common stock of a firm owned by
a broad group of unrelated individual or institutional investors.
par value (stock)
A relatively useless value for a
stock established for legal purposes in the firm’s corporate
charter.
preemptive right
Allows common stockholders to
maintain their proportionate
ownership in the corporation
when new shares are issued.
dilution of ownership
Occurs when a new stock issue
results in each present shareholder having a claim on a
smaller part of the firm’s
earnings than previously.
rights
Financial instruments that permit
stockholders to purchase additional shares at a price below the
market price, in direct proportion
to their number of owned shares.
authorized shares
The number of shares of common
stock that a firm’s corporate
charter allows it to issue.
outstanding shares
The number of shares of common
stock held by the public.
treasury stock
The number of shares of outstanding stock that have been
repurchased by the firm.
issued shares
The number of shares of common
stock that have been put into
circulation; the sum of outstanding shares and treasury stock.
The common stock of a firm can be privately owned by a single individual,
closely owned by a small group of investors (such as a family), or publicly owned
by a broad group of unrelated individual or institutional investors. Typically,
small corporations are privately or closely owned; if their shares are traded, this
occurs infrequently and in small amounts. Large corporations, which are emphasized in the following discussions, are publicly owned, and their shares are generally actively traded on the major securities exchanges described in Chapter 1.
Par Value
Unlike bonds, which always have a par value, common stock may be sold with or
without a par value. The par value of a common stock is a relatively useless value
established for legal purposes in the firm’s corporate charter. It is generally quite
low, about $1.
Firms often issue stock with no par value, in which case they may assign the
stock a value or record it on the books at the price at which it is sold. A low par
value may be advantageous in states where certain corporate taxes are based on
the par value of stock; if a stock has no par value, the tax may be based on an
arbitrarily determined per-share figure.
Preemptive Rights
The preemptive right allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued. It allows existing
shareholders to maintain voting control and protects them against the dilution of
their ownership. Dilution of ownership usually results in the dilution of earnings,
because each present shareholder has a claim on a smaller part of the firm’s earnings than previously.
In a rights offering, the firm grants rights to its shareholders. These financial
instruments permit stockholders to purchase additional shares at a price below
the market price, in direct proportion to their number of owned shares. Rights
are used primarily by smaller corporations whose shares are either closely owned
or publicly owned and not actively traded. In these situations, rights are an
important financing tool without which shareholders would run the risk of losing
their proportionate control of the corporation. From the firm’s viewpoint, the use
of rights offerings to raise new equity capital may be less costly and may generate
more interest than a public offering of stock.
Authorized, Outstanding, and Issued Shares
A firm’s corporate charter indicates how many authorized shares it can issue. The
firm cannot sell more shares than the charter authorizes without obtaining
approval through a shareholder vote. To avoid later having to amend the charter,
firms generally attempt to authorize more shares than they initially plan to issue.
Authorized shares become outstanding shares when they are held by the public. If the firm repurchases any of its outstanding shares, these shares are recorded
as treasury stock and are no longer considered to be outstanding shares. Issued
shares are the shares of common stock that have been put into circulation; they
represent the sum of outstanding shares and treasury stock.
CHAPTER 7
EXAMPLE
Stock Valuation
311
Golden Enterprises, a producer of medical pumps, has the following stockholders’ equity account on December 31:
Stockholders’ Equity
Common stock—$0.80 par value:
Authorized 35,000,000 shares;
issued 15,000,000 shares
Paid-in capital in excess of par
$ 12,000,000
63,000,000
Retained earnings
3
1
,0
0
0
,0
0
0
$106,000,000
Less: Cost of treasury stock (1,000,000 shares)
Total stockholders’ equity
4,000,000
$
1
0
2
,0
0
0
,0
0
0
How many shares of additional common stock can Golden sell without gaining approval from its shareholders? The firm has 35 million authorized shares, 15
million issued shares, and 1 million shares of treasury stock. Thus 14 million
shares are outstanding (15 million issued shares 1 million shares of treasury
stock), and Golden can issue 21 million additional shares (35 million authorized
shares 14 million outstanding shares) without seeking shareholder approval.
This total includes the treasury shares currently held, which the firm can reissue
to the public without obtaining shareholder approval.
Voting Rights
supervoting shares
Stock that carries with it
multiple votes per share rather
than the single vote per share
typically given on regular shares
of common stock.
nonvoting common stock
Common stock that carries no
voting rights; issued when the
firm wishes to raise capital
through the sale of common
stock but does not want to give
up its voting control.
proxy statement
A statement giving the votes of a
stockholder to another party.
Generally, each share of common stock entitles its holder to one vote in the election of directors and on special issues. Votes are generally assignable and may be
cast at the annual stockholders’ meeting.
In recent years, many firms have issued two or more classes of common
stock; they differ mainly in having unequal voting rights. A firm can use different
classes of stock as a defense against a hostile takeover in which an outside group,
without management support, tries to gain voting control of the firm by buying
its shares in the marketplace. Supervoting shares of stock give each owner multiple votes. When supervoting shares are issued to “insiders,” an outside group,
whose shares have only one vote each typically cannot obtain enough votes to
gain control of the firm. At other times, a class of nonvoting common stock is
issued when the firm wishes to raise capital through the sale of common stock but
does not want to give up its voting control.
When different classes of common stock are issued on the basis of unequal
voting rights, class A common is typically—but not universally—designated as
nonvoting, and class B common has voting rights. Generally, higher classes of
shares (class A, for example) are given preference in the distribution of earnings
(dividends) and assets; lower-class shares, in exchange, receive voting rights.
Treasury stock, which is held within the corporation, generally does not have
voting rights, does not earn dividends, and does not have a claim on assets in
liquidation.
Because most small stockholders do not attend the annual meeting to vote, they
may sign a proxy statement giving their votes to another party. The solicitation of
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Important Financial Concepts
proxy battle
The attempt by a nonmanagement
group to gain control of the management of a firm by soliciting a
sufficient number of proxy votes.
proxies from shareholders is closely controlled by the Securities and Exchange
Commission to ensure that proxies are not being solicited on the basis of false or
misleading information. Existing management generally receives the stockholders’
proxies, because it is able to solicit them at company expense.
Occasionally, when the firm is widely owned, outsiders may wage a proxy
battle to unseat the existing management and gain control. To win a corporate
election, votes from a majority of the shares voted are required. However, the
odds of a nonmanagement group winning a proxy battle are generally slim.
Dividends
The payment of dividends to the firm’s shareholders is at the discretion of the
corporation’s board of directors. Most corporations pay dividends quarterly.
Dividends may be paid in cash, stock, or merchandise. Cash dividends are the
most common, merchandise dividends the least.
Common stockholders are not promised a dividend, but they come to expect
certain payments on the basis of the historical dividend pattern of the firm.
Before dividends are paid to common stockholders, the claims of the government,
all creditors, and preferred stockholders must be satisfied. Because of the importance of the dividend decision to the growth and valuation of the firm, dividends
are discussed in greater detail in Chapter 13.
International Stock Issues
American depositary receipts
(ADRs)
Claims issued by U.S. banks
representing ownership of
shares of a foreign company’s
stock held on deposit by the U.S.
bank in the foreign market and
issued in dollars to U.S.
investors.
Although the international market for common stock is not so large as the international market for bonds, cross-border issuance and trading of common stock
have increased dramatically in the past 20 years.
Some corporations issue stock in foreign markets. For example, the stock of
General Electric trades in Frankfurt, London, Paris, and Tokyo; the stocks of AOL
Time Warner and Microsoft trade in Frankfurt; and the stock of McDonald’s
trades in Frankfurt and Paris. The London, Frankfurt, and Tokyo markets are the
most popular. Issuing stock internationally broadens the ownership base and also
helps a company to integrate itself into the local business scene. A listing on a foreign stock exchange both increases local business press coverage and serves as
effective corporate advertising. Having locally traded stock can also facilitate
corporate acquisitions, because shares can be used as an acceptable method
of payment.
Foreign corporations have also discovered the benefits of trading their stock
in the United States. The disclosure and reporting requirements mandated by the
U.S. Securities and Exchange Commission have historically discouraged all but
the largest foreign firms from directly listing their shares on the New York Stock
Exchange or the American Stock Exchange. For example, in 1993, Daimler-Benz
(now Daimler Chrysler) became the first large German company to be listed on
the NYSE.
Alternatively, most foreign companies tap the U.S. market through American
depositary receipts (ADRs). These are claims issued by U.S. banks representing
ownership of shares of a foreign company’s stock held on deposit by the U.S.
bank in the foreign market. Because ADRs are issued, in dollars, by a U.S. bank
to U.S. investors, they are subject to U.S. securities laws. Yet they still give
investors the opportunity to diversify their portfolios internationally.
CHAPTER 7
Stock Valuation
313
Preferred Stock
par-value preferred stock
Preferred stock with a stated
face value that is used with the
specified dividend percentage to
determine the annual dollar
dividend.
no-par preferred stock
Preferred stock with no stated
face value but with a stated
annual dollar dividend.
Preferred stock gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic dividend,
which is stated either as a percentage or as a dollar amount. How the dividend is
specified depends on whether the preferred stock has a par value, which, as in
common stock, is a relatively useless stated value established for legal purposes.
Par-value preferred stock has a stated face value, and its annual dividend is specified as a percentage of this value. No-par preferred stock has no stated face value,
but its annual dividend is stated in dollars. Preferred stock is most often issued by
public utilities, by acquiring firms in merger transactions, and by firms that are
experiencing losses and need additional financing.
Basic Rights of Preferred Stockholders
The basic rights of preferred stockholders are somewhat more favorable than the
rights of common stockholders. Preferred stock is often considered quasi-debt
because, much like interest on debt, it specifies a fixed periodic payment (dividend). Of course, as ownership, preferred stock is unlike debt in that it has no
maturity date. Because they have a fixed claim on the firm’s income that takes
precedence over the claim of common stockholders, preferred stockholders are
exposed to less risk. They are consequently not normally given a voting right.
Preferred stockholders have preference over common stockholders in the distribution of earnings. If the stated preferred stock dividend is “passed” (not paid)
by the board of directors, the payment of dividends to common stockholders is
prohibited. It is this preference in dividend distribution that makes common
stockholders the true risk takers.
Preferred stockholders are also usually given preference over common stockholders in the liquidation of assets in a legally bankrupt firm, although they must
“stand in line” behind creditors. The amount of the claim of preferred stockholders in liquidation is normally equal to the par or stated value of the preferred stock.
Features of Preferred Stock
A number of features are generally included as part of a preferred stock issue.
These features, along with the stock’s par value, the amount of dividend payments, the dividend payment dates, and any restrictive covenants, are specified in
an agreement similar to a bond indenture.
cumulative preferred stock
Preferred stock for which all
passed (unpaid) dividends in
arrears, along with the current
dividend, must be paid before
dividends can be paid to common
stockholders.
Restrictive Covenants The restrictive covenants in a preferred stock issue
are aimed at ensuring the firm’s continued existence and regular payment of the
dividend. These covenants include provisions about passing dividends, the sale of
senior securities, mergers, sales of assets, minimum liquidity requirements, and
repurchases of common stock. The violation of preferred stock covenants usually
permits preferred stockholders either to obtain representation on the firm’s
board of directors or to force the retirement of their stock at or above its par or
stated value.
Cumulation Most preferred stock is cumulative with respect to any dividends passed. That is, all dividends in arrears, along with the current dividend,
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Important Financial Concepts
noncumulative preferred stock
Preferred stock for which passed
(unpaid) dividends do not
accumulate.
conversion feature
(preferred stock)
A feature of convertible preferred stock that allows holders
to change each share into a
stated number of shares of
common stock.
must be paid before dividends can be paid to common stockholders. If preferred
stock is noncumulative, passed (unpaid) dividends do not accumulate. In this
case, only the current dividend must be paid before dividends can be paid to common stockholders. Because the common stockholders can receive dividends only
after the dividend claims of preferred stockholders have been satisfied, it is in the
firm’s best interest to pay preferred dividends when they are due.1
Other Features Preferred stock is generally callable—the issuer can retire
outstanding stock within a certain period of time at a specified price. The call
option generally cannot be exercised until a specified date. The call price is normally set above the initial issuance price, but it may decrease as time passes.
Making preferred stock callable provides the issuer with a way to bring the
fixed-payment commitment of the preferred issue to an end if conditions in the
financial markets make it desirable to do so.
Preferred stock quite often contains a conversion feature that allows holders
of convertible preferred stock to change each share into a stated number of shares
of common stock. Sometimes the number of shares of common stock that the
preferred stock can be exchanged for changes according to a prespecified formula.
Issuing Common Stock
venture capital
Privately raised external equity
capital used to fund early-stage
firms with attractive growth
prospects.
venture capitalists (VCs)
Providers of venture capital;
typically, formal businesses
that maintain strong oversight
over the firms they invest in and
that have clearly defined exit
strategies.
Because of the high risk associated with a business startup, a firm’s initial financing typically comes from its founders in the form of a common stock investment.
Until the founders have made an equity investment, it is highly unlikely that others will contribute either equity or debt capital. Early-stage investors in the firm’s
equity, as well as lenders who provide debt capital, want to be assured that they
are taking no more risk than the founding owner(s). In addition, they want confirmation that the founders are confident enough in their vision for the firm that
they are willing to risk their own money.
The initial nonfounder financing for business startups with attractive growth
prospects comes from private equity investors. Then, as the firm establishes the
viability of its product or service offering and begins to generate revenues, cash
flow, and profits, it will often “go public” by issuing shares of common stock to a
much broader group of investors.
Before we consider the initial public sales of equity, let’s review some of the
key aspects of early-stage equity financing in firms that have attractive growth
prospects.
Venture Capital
The initial external equity financing privately raised by firms, typically earlystage firms with attractive growth prospects, is called venture capital. Those who
provide venture capital are known as venture capitalists (VCs). They typically are
1. Most preferred stock is cumulative, because it is difficult to sell noncumulative stock. Common stockholders obviously prefer issuance of noncumulative preferred stock, because it does not place them in quite so risky a position.
But it is often in the best interest of the firm to sell cumulative preferred stock because of its lower cost.
Most preferred stock has a fixed dividend, but some firms issue adjustable-rate (floating-rate) preferred stock
(ARPS) whose dividend rate is tied to interest rates on specific government securities. Rate adjustments are commonly made quarterly. ARPS offers investors protection against sharp rises in interest rates, which means that the
issue can be sold at an initially lower dividend rate.
CHAPTER 7
angel capitalists (angels)
Wealthy individual investors
who do not operate as a business
but invest in promising earlystage companies in exchange for
a portion of the firm’s equity.
Stock Valuation
315
formal business entities that maintain strong oversight over the firms they invest
in and that have clearly defined exit strategies. Less visible early-stage investors
called angel capitalists (or angels) tend to be investors who do not actually operate as a business; they are often wealthy individual investors who are willing to
invest in promising early-stage companies in exchange for a portion of the firm’s
equity. Although angels play a major role in early-stage equity financing, we will
focus on VCs because of their more formal structure and greater public visibility.
Organization and Investment Stages Institutional venture capital investors
tend to be organized in one of four basic ways, as described in Table 7.2. The VC
limited partnership is by far the dominant structure. These funds have as their
sole objective to earn high returns, rather than to obtain access to the companies
in order to sell or buy other products or services.
VCs can invest in early-stage companies, later-stage companies, or buyouts
and acquisitions. Generally, about 40 to 50 percent of VC investments are
devoted to early-stage companies (for startup funding and expansion) and a similar percentage to later-stage companies (for marketing, production expansion,
and preparation for public offering); the remaining 5 to 10 percent are devoted to
the buyout or acquisition of other companies. Generally, VCs look for compound
rates of return ranging from 20 to 50 percent or more, depending on both the
development stage and the attributes of each company. Earlier-stage investments
tend to demand higher returns than later-stage financing because of the higher
risk associated with the earlier stages of a firm’s growth.
Deal Structure and Pricing Regardless of the development stage, venture
capital investments are made under a legal contract that clearly allocates responsibilities and ownership interests between existing owners (founders) and the VC
fund or limited partnership. The terms of the agreement will depend on numerous
TABLE 7.2
Organization of Institutional Venture Capital
Investors
Organization
Description
Small business investment
companies (SBICs)
Corporations chartered by the federal government that can
borrow at attractive rates from the U.S. Treasury and use
the funds to make venture capital investments in private
companies.
Financial VC funds
Subsidiaries of financial institutions, particularly banks, set
up to help young firms grow and, it is hoped, become major
customers of the institution.
Corporate VC funds
Firms, sometimes subsidiaries, established by nonfinancial
firms, typically to gain access to new technologies that the
corporation can access to further its own growth.
VC limited partnerships
Limited partnerships organized by professional VC firms, who
serve as the general partner and organize, invest, and manage
the partnership using the limited partners’ funds; the professional VCs ultimately liquidate the partnership and distribute
the proceeds to all partners.
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Important Financial Concepts
factors related to the founders; the business structure, stage of development, and
outlook; and other market and timing issues. The specific financial terms will, of
course, depend on the value of the enterprise, the amount of funding, and the perceived risk. To control the VC’s risk, various covenants are included in the agreement, and the actual funding may be pegged to the achievement of measurable
milestones. The VC will negotiate numerous other provisions into the contract,
both to ensure the firm’s success and to control its risk exposure. The contract
will have an explicit exit strategy for the VC that may be tied both to measurable
milestones and to time.
The amount of equity to which the VC is entitled will, of course, depend on
the value of the firm, the terms of the contract, the exit terms, and the minimum
compound rate of return required by the VC on its investment. Although each
VC investment is unique and no standard contract exists, the transaction will be
structured to provide the VC with a high rate of return that is consistent with the
typically high risk of such transactions. The exit strategy of most VC investments
is to take the firm public through an initial public offering.
Going Public
initial public offering (IPO)
The first public sale of a firm’s
stock.
prospectus
A portion of a security registration statement that describes the
key aspects of the issue, the
issuer, and its management and
financial position.
red herring
A preliminary prospectus made
available to prospective
investors during the waiting
period between the registration
statement’s filing with the SEC
and its approval.
When a firm wishes to sell its stock in the primary market, it has three alternatives. It can make (1) a public offering, in which it offers its shares for sale to the
general public; (2) a rights offering, in which new shares are sold to existing
stockholders; or (3) a private placement, in which the firm sells new securities
directly to an investor or group of investors. Here we focus on public offerings,
particularly the initial public offering (IPO), which is the first public sale of a
firm’s stock. IPOs are typically made by small, rapidly growing companies that
either require additional capital to continue expanding or have met a milestone
for going public that was established in a contract signed earlier in order to
obtain VC funding.
To go public, the firm must first obtain the approval of its current shareholders, the investors who own its privately issued stock. Next, the company’s auditors and lawyers must certify that all documents for the company are legitimate.
The company then finds an investment bank willing to underwrite the offering.
This underwriter is responsible for promoting the stock and facilitating the sale of
the company’s IPO shares. The underwriter often brings in other investment banking firms as participants. We’ll discuss the role of the investment banker in more
detail in the next section.
The company files a registration statement with the SEC. One portion of the
registration statement is called the prospectus. It describes the key aspects of the
issue, the issuer, and its management and financial position. During the waiting
period between the statement’s filing and its approval, prospective investors can
receive a preliminary prospectus. This preliminary version is called a red herring,
because a notice printed in red on the front cover indicates the tentative nature of
the offer. The cover of the preliminary prospectus describing the 2002 stock issue
of Ribapharm, Inc. is shown in Figure 7.1. Note the red herring printed vertically
on its left edge.
After the SEC approves the registration statement, the investment community
can begin analyzing the company’s prospects. However, from the time it files until
at least one month after the IPO is complete, the company must observe a quiet
period, during which there are restrictions on what company officials may say
CHAPTER 7
FIGURE 7.1
Stock Valuation
317
Cover of a Preliminary Prospectus for a Stock Issue
Some of the key factors related to the 2002 common stock issue by
Ribapharm, Inc. are summarized on the cover of the prospectus. The
type printed vertically on the left edge is normally red, which explains its
name “red herring.” (Source: Ribapharm, Inc., March 21, 2002, p. 1.)
about the company. The purpose of the quiet period is to make sure that all potential investors have access to the same information about the company—the information presented in the preliminary prospectus—and not to any unpublished data
that might give them an unfair advantage.
The investment bankers and company executives promote the company’s
stock offering through a road show, a series of presentations to potential
318
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Important Financial Concepts
FOCUS ON PRACTICE
Investors Eat Up Weight Watchers Shares
After a sluggish year for initial
public offerings (IPOs) of common
stock, companies rushed to tap the
equity markets again during the
last few months of 2001. Many investors feasted on 17.4 million
shares of Weight Watchers
International, which went public
on November 14, just before the
holiday eating season began. Investor appetite raised the offering
price to $24 per share, up from the
original range of $21 to $23 set by
lead underwriters Credit Suisse
First Boston and Goldman, Sachs
& Co. Net proceeds from the IPO,
after underwriting costs, were
$417 million. The share price fattened throughout the day, closing
up 19 percent at $28.50 on the first
day. A month later, the shares
were trading at the $32 level.
“The company’s timing for doing this offering now is good,” said
John LaRosa, research director of
investment banker
Financial intermediary that
specializes in selling new
security issues and advising
firms with regard to major
financial transactions.
underwriting
The role of the investment banker
in bearing the risk of reselling, at
a profit, the securities purchased
from an issuing corporation at an
agreed-on price.
underwriting syndicate
A group formed by an investment
banker to share the financial risk
associated with underwriting
new securities.
selling group
A large number of brokerage
firms that join the originating
investment banker(s); each
accepts responsibility for selling
a certain portion of a new
security issue on a commission
basis.
Marketdata Enterprises Inc., a research firm that focuses on health
care industries. “Their name is well
known and their earnings have
been strong.” Other reasons for the
popularity of the Weight Watchers’
IPO included its global presence
and strong retail sales. Its long history of profitability, its easily understood business plan, and its familiar product made it stand out from
the crowd of Internet and other
technology IPOs.
Was Weight Watchers a
good investment at $32 a share?
Only time will tell. Some analysts
thought the stock was overpriced.
Although the company’s $1.5 billion in retail sales is attractive,
franchisees and licensees such as
Heinz retain most of the profits on
food sales. The company also
gained over $481 million in debt
when Artal Luxembourg S.A., a
private European investment com-
In Practice
pany, bought Weight Watchers
from H. J. Heinz in 1999. The debt
burden that Weight Watchers
carries exceeds its assets, resulting in a negative net worth of almost $200 million. Unlike most
IPOs in which the company retains
the proceeds, Artal—the selling
shareholders—kept the proceeds
rather than reducing the Weight
Watchers debt. The company
was also trading at a high
price/earnings multiple, about
40 times.
Sources: Adapted from Robert Barker,
“Weight Watchers: A Little Debt Heavy?”
Business Week (December 10, 2001), p. 100;
Alan Clendenning, “Weight Watchers
Shares Surge,” AP Online (November 15,
2001), downloaded from www.findarticles.
com; Elena Molinari, “IPO Market Ends Sluggish Year with a Boom,” Reuters Business
Report (December 9, 2001), downloaded
from eLibrary, ask.elibrary.com; and Tania
Padgett, “Weight Watchers New Plan Offers
IPO,” Newsday (November 13, 2001), p. A71,
downloaded from eLibrary, ask.elibrary.com.
investors around the country and sometimes overseas. In addition to providing
investors with information about the new issue, road show sessions help the
investment bankers gauge the demand for the offering and set an expected pricing
range. After the underwriter sets terms and prices the issue, the SEC must approve
the offering.
The Investment Banker’s Role
Most public offerings are made with the assistance of an investment banker. The
investment banker is a financial intermediary (such as Salomon Brothers or
Goldman, Sachs) that specializes in selling new security issues and advising firms
with regard to major financial transactions. The main activity of the investment
banker is underwriting. This process involves purchasing the security issue from
the issuing corporation at an agreed-on price and bearing the risk of reselling it to
the public at a profit. The investment banker also provides the issuer with advice
about pricing and other important aspects of the issue.
In the case of very large security issues, the investment banker brings in other
bankers as partners to form an underwriting syndicate. The syndicate shares the
financial risk associated with buying the entire issue from the issuer and reselling
the new securities to the public. The originating investment banker and the syndicate members put together a selling group, normally made up of themselves and a
CHAPTER 7
Stock Valuation
319
FIGURE 7.2
The Selling Process for
a Large Security Issue
The investment banker hired
by the issuing corporation
may form an underwriting
syndicate. The underwriting
syndicate buys the entire
security issue from the issuing corporation at an agreedon price. The underwriter
then has the opportunity (and
bears the risk) of reselling the
issue to the public at a profit.
Both the originating investment banker and the other
syndicate members put
together a selling group to
sell the issue on a commission basis to investors.
Issuing
Corporation
Underwriting Syndicate
Investment
Banker
Investment
Banker
Originating
Investment
Banker
Investment
Banker
Investment
Banker
Selling Group
Purchasers of Securities
large number of brokerage firms. Each member of the selling group accepts the
responsibility for selling a certain portion of the issue and is paid a commission
on the securities it sells. The selling process for a large security issue is depicted in
Figure 7.2.
Compensation for underwriting and selling services typically comes in the
form of a discount on the sale price of the securities. For example, an investment
banker may pay the issuing firm $24 per share for stock that will be sold for $26
per share. The investment banker may then sell the shares to members of the selling group for $25.25 per share. In this case, the original investment banker earns
$1.25 per share ($25.25 sale price $24 purchase price). The members of the
selling group earn 75 cents for each share they sell ($26 sale price $25.25 purchase price). Although some primary security offerings are directly placed by the
issuer, the majority of new issues are sold through public offering via the mechanism just described.
Interpreting Stock Quotations
The financial manager needs to stay abreast of the market values of the firm’s outstanding stock, whether it is traded on an organized exchange, over the counter,
or in international markets. Similarly, existing and prospective stockholders need
to monitor the prices of the securities they own because these prices represent the
current value of their investments. Price quotations, which include current price
data along with statistics on recent price behavior, are readily available for
actively traded stocks. The most up-to-date “quotes” can be obtained electronically, via a personal computer. Price information is available from stockbrokers
and is widely published in news media. Popular sources of daily security price
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PART 2
Important Financial Concepts
Hint Preferred stock
quotations are listed separately
and include only four data
items: dividend, dividend yield,
closing price, and change in
closing price from the previous
day.
quotations include financial newspapers, such as the Wall Street Journal and
Investor’s Business Daily, and the business sections of daily general newspapers.
Figure 7.3 includes an excerpt from the NYSE quotations, reported in the
Wall Street Journal of March 18, 2002, for transactions through the close of
trading on Friday, March 15, 2002. We’ll look at the quotations for common
stock for McDonalds, highlighted in the figure. The quotations show that stock
prices are quoted in dollars and cents.
The first column gives the percent change in the stock’s closing price for the
calendar year to date. You can see that McDonalds’ price has increased 8.5 percent (8.5) since the start of 2002. The next two columns, labeled “HI” and
“LO,” show the highest and lowest prices at which the stock sold during the preceding 52 weeks. McDonalds common stock, for example, traded between
$24.75 and $31.00 during the 52-week period that ended March 15, 2002.
Listed to the right of the company’s name is its stock symbol; McDonalds goes by
“MCD.” The figure listed right after the stock symbol under “DIV” is the annual
cash dividend paid on each share of stock. The dividend for McDonalds was
$0.23 per share. The next item, labeled “YLD%,” is the dividend yield, which is
found by dividing the stated dividend by the last share price. The dividend yield
for McDonalds is 0.8 percent (0.23 28.72 0.0080 0.8%).
FIGURE 7.3
Stock Quotations
Selected stock quotations
for March 15, 2002
YTD 52 WEEKS
LO
% CHG HI
STOCK (SYM)
YLD
VOL
DIV % PE 100S LAST
NET
CHG
McDonalds
Source: Wall Street Journal, March 18, 2002, p. C4.
CHAPTER 7
Stock Valuation
321
The price/earnings (P/E) ratio, labeled “PE,” is next. It is calculated by dividing the closing market price by the firm’s most recent annual earnings per share
(EPS). The price/earnings (P/E) ratio, as noted in Chapter 2, measures the amount
investors are willing to pay for each dollar of the firm’s earnings. McDonalds’ P/E
ratio was 23—the stock was trading at 23 times it earnings. The P/E ratio is
believed to reflect investor expectations concerning the firm’s future prospects:
Higher P/E ratios reflect investor optimism and confidence; lower P/E ratios
reflect investor pessimism and concern.
The daily volume, labeled “VOL 100s,” follows the P/E ratio. Here the day’s
sales are quoted in lots of 100 shares. The value 59195 for McDonalds indicates
that 5,919,500 shares of its common stock were traded on March 15, 2002. The
next column, labeled “LAST,” contains the last price at which the stock sold on
the given day. The value for McDonalds was $28.72. The final column, “NET
CHG,” indicates the change in the closing price from that on the prior trading
day. McDonalds closed up $0.57 from March 14, 2002, which means the closing
price on that day was $28.15.
Similar quotations systems are used for stocks that trade on other exchanges
such as the American Stock Exchange (AMEX) and for the over-the-counter
(OTC) exchange’s Nasdaq National Market Issues. Also note that when a stock
(or bond) issue is not traded on a given day, it generally is not quoted in the
financial and business press.
Review Questions
7–2
What risks do common stockholders take that other suppliers of longterm capital do not?
7–3 How does a rights offering protect a firm’s stockholders against the dilution of ownership?
7–4 Explain the relationships among authorized shares, outstanding shares,
treasury stock, and issued shares.
7–5 What are the advantages to both U.S.-based and foreign corporations of
issuing stock outside their home markets? What are American depositary
receipts (ADRs)?
7–6 What claims do preferred stockholders have with respect to distribution of
earnings (dividends) and assets?
7–7 Explain the cumulative feature of preferred stock. What is the purpose of
a call feature in a preferred stock issue?
7–8 What is the difference between a venture capitalist (VC) and an angel capitalist (angel)?
7–9 Into what bodies are institutional VCs most commonly organized? How
are their deals structured and priced?
7–10 What general procedures must a private firm go through in order to go
public via an initial public offering (IPO)?
7–11 What role does an investment banker play in a public offering? Explain
the sequence of events in the issuing of stock.
7–12 Describe the key items of information included in a stock quotation. What
information does the stock’s price/earnings (P/E) ratio provide?
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Important Financial Concepts
LG5
7.3 Common Stock Valuation
Common stockholders expect to be rewarded through periodic cash dividends
and an increasing—or at least nondeclining—share value. Like current owners,
prospective owners and security analysts frequently estimate the firm’s value.
Investors purchase the stock when they believe that it is undervalued—when its
true value is greater than its market price. They sell the stock when they feel that
it is overvalued—when its market price is greater than its true value.
In this section, we will describe specific stock valuation techniques. First,
though, we will look at the concept of an efficient market, which questions
whether the prices of actively traded stocks can differ from their true values.
Market Efficiency2
Economically rational buyers and sellers use their assessment of an asset’s risk
and return to determine its value. To a buyer, the asset’s value represents the
maximum price that he or she would pay to acquire it; a seller views the asset’s
value as a minimum sale price. In competitive markets with many active participants, such as the New York Stock Exchange, the interactions of many buyers
and sellers result in an equilibrium price—the market value—for each security.
This price reflects the collective actions that buyers and sellers take on the basis of
all available information. Buyers and sellers are assumed to digest new information immediately as it becomes available and, through their purchase and sale
activities, to create a new market equilibrium price quickly.
Hint Be sure to clarify in
your own mind the difference
between the required return
and the expected return.
Required return is what an
investor has to have to invest in
a specific asset, and expected
return is the return an investor
thinks she will get if the asset is
purchased.
expected return, k̂
The return that is expected to be
earned on a given asset each
period over an infinite time
horizon.
Hint
This relationship
between the expected return
and the required return can be
seen in Equation 7.1, where a
decrease in asset price will
result in an increase in the
expected return.
Market Adjustment to New Information
The process of market adjustment to new information can be viewed in terms of
rates of return. From Chapter 5, we know that for a given level of risk, investors
require a specified periodic return—the required return, k—which can be estimated by using beta and CAPM. At each point in time, investors estimate the
expected return, k̂—the return that is expected to be earned on a given asset each
period over an infinite time horizon. The expected return can be estimated by
using a simplified form of Equation 5.1:
Expected benefit during each period
k̂ Current price of asset
(7.1)
Whenever investors find that the expected return is not equal to the required
return (k̂ k), a market price adjustment occurs. If the expected return is less than
the required return (k̂ k), investors sell the asset, because they do not expect it to
earn a return commensurate with its risk. Such action drives the asset’s price
down, which (assuming no change in expected benefits) causes its expected return
to rise to the level of its required return. If the expected return were above the
2. A great deal of theoretical and empirical research has been performed in the area of market efficiency. For purposes of this discussion, generally accepted beliefs about market efficiency are described, rather than the technical
aspects of the various forms of market efficiency and their theoretical implications. For a good discussion of the theory and evidence relative to market efficiency, see William L. Megginson, Corporate Finance Theory (Boston, MA:
Addison Wesley, 1997), Chapter 3.
CHAPTER 7
Stock Valuation
323
required return (k̂ k), investors would buy the asset, driving its price up and its
expected return down to the point where it equals the required return.
EXAMPLE
The common stock of Alton Industries (AI) is currently selling for $50 per share,
and market participants expect it to generate benefits of $6.50 per share during
each coming period. In addition, the risk-free rate, RF, is currently 7%; the market return, km, is 12%; and the stock’s beta, bAI, is 1.20. When these values are
substituted into Equation 7.1, the firm’s current expected return, k̂0, is
$6.50
k̂0 13%
$50.00 When the appropriate values are substituted into the CAPM (Equation 5.8), the
current required return, k0, is
k0 7% [1.20
(12% 7%)] 7% 6% 13%
Because k̂0 k0, the market is currently in equilibrium, and the stock is fairly
priced at $50 per share.
Assume that a press release announces that a major product liability suit has
been filed against Alton Industries. As a result, investors immediately adjust their
risk assessment upward, raising the firm’s beta from 1.20 to 1.40. The new
required return, k1, becomes
k1 7% [1.40
(12% 7%)] 7% 7% 14%
Because the expected return of 13% is now below the required return of 14%,
many investors sell the stock—driving its price down to about $46.43—the price
that will result in a 14% expected return, k̂1.
$6.50
k̂1 14
%
$46.43 The new price of $46.43 brings the market back into equilibrium, because the
expected return now equals the required return.
The Efficient-Market Hypothesis
efficient-market hypothesis
Theory describing the behavior
of an assumed “perfect” market
in which (1) securities are typically in equilibrium, (2) security
prices fully reflect all public
information available and react
swiftly to new information, and,
(3) because stocks are fairly
priced, investors need not waste
time looking for mispriced
securities.
As noted in Chapter 1, active markets such as the New York Stock Exchange are
efficient—they are made up of many rational investors who react quickly and
objectively to new information. The efficient-market hypothesis, which is the basic
theory describing the behavior of such a “perfect” market, specifically states that
1. Securities are typically in equilibrium, which means that they are fairly priced
and that their expected returns equal their required returns.
2. At any point in time, security prices fully reflect all public information available about the firm and its securities,3 and these prices react swiftly to new
information.
3. Those market participants who have nonpublic—inside—information may have an unfair advantage that enables
them to earn an excess return. Since the mid-1980s disclosure of the insider-trading activities of a number of wellknown financiers and investors, major national attention has been focused on the “problem” of insider trading and
its resolution. Clearly, those who trade securities on the basis of inside information have an unfair and illegal advantage. Empirical research has confirmed that those with inside information do indeed have an opportunity to earn an
excess return. Here we ignore this possibility, given its illegality and that given enhanced surveillance and enforcement by the securities industry and the government have in recent years (it appears) significantly reduced insider
trading. We, in effect, assume that all relevant information is public and that therefore the market is efficient.
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Important Financial Concepts
3. Because stocks are fully and fairly priced, investors need not waste their time
trying to find and capitalize on mispriced (undervalued or overvalued)
securities.
Not all market participants are believers in the efficient-market hypothesis.
Some feel that it is worthwhile to search for undervalued or overvalued securities
and to trade them to profit from market inefficiencies. Others argue that it is
mere luck that would allow market participants to anticipate new information
correctly and as a result earn excess returns—that is, actual returns greater than
required returns. They believe it is unlikely that market participants can over the
long run earn excess returns. Contrary to this belief, some well-known investors
such as Warren Buffett and Peter Lynch have over the long run consistently
earned excess returns on their portfolios. It is unclear whether their success is the
result of their superior ability to anticipate new information or of some form of
market inefficiency.
Throughout this text we ignore the disbelievers and continue to assume market efficiency. This means that the terms “expected return” and “required
return” are used interchangeably, because they should be equal in an efficient
market. This also means that stock prices accurately reflect true value based on
risk and return. In other words, we will operate under the assumption that the
market price at any point in time is the best estimate of value. We’re now ready to
look closely at the mechanics of stock valuation.
The Basic Stock Valuation Equation
Like the value of a bond, which we discussed in Chapter 6, the value of a share of
common stock is equal to the present value of all future cash flows (dividends)
that it is expected to provide over an infinite time horizon.4 Although a stockholder can earn capital gains by selling stock at a price above that originally paid,
what is really sold is the right to all future dividends. What about stocks that are
not expected to pay dividends in the foreseeable future? Such stocks have a value
attributable to a distant dividend expected to result from sale of the company or
liquidation of its assets. Therefore, from a valuation viewpoint, only dividends
are relevant.
By redefining terms, the basic valuation model in Equation 6.5 can be specified for common stock, as given in Equation 7.2:
D∞
D1
D2
. . . P0 (1 ks )1
(1 ks )2
(1 ks )∞
(7.2)
where
P0 value of common stock
Dt per-share dividend expected at the end of year t
ks required return on common stock
4. The need to consider an infinite time horizon is not critical, because a sufficiently long period—say, 50 years—
will result in about the same present value as an infinite period for moderate-sized required returns. For example, at
15%, a dollar to be received 50 years from now, PVIF15%,50yrs , is worth only about $0.001 today.
CHAPTER 7
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325
The equation can be simplified somewhat by redefining each year’s dividend, Dt,
in terms of anticipated growth. We will consider three models here: zero-growth,
constant-growth, and variable-growth.
Zero-Growth Model
zero-growth model
An approach to dividend
valuation that assumes a
constant, nongrowing dividend
stream.
The simplest approach to dividend valuation, the zero-growth model, assumes a
constant, nongrowing dividend stream. In terms of the notation already introduced,
D1 D2 . . . D∞
When we let D1 represent the amount of the annual dividend, Equation 7.2 under
zero growth reduces to
P0 D1
∞
1
t D1
t1 (1 ks )
(PVIFAks ,∞) D1
D1
1
ks
ks
(7.3)
The equation shows that with zero growth, the value of a share of stock would
equal the present value of a perpetuity of D1 dollars discounted at a rate ks. (Perpetuities were introduced in Chapter 4; see Equation 4.19 and the related discussion.)
EXAMPLE
The dividend of Denham Company, an established textile producer, is expected
to remain constant at $3 per share indefinitely. If the required return on its stock
is 15%, the stock’s value is $20 ($3 0.15) per share.
Preferred Stock Valuation Because preferred stock typically provides its
holders with a fixed annual dividend over its assumed infinite life, Equation 7.3
can be used to find the value of preferred stock. The value of preferred stock can
be estimated by substituting the stated dividend on the preferred stock for D1 and
the required return for ks in Equation 7.3. For example, a preferred stock paying
a $5 stated annual dividend and having a required return of 13 percent would
have a value of $38.46 ($5 0.13) per share.
Constant-Growth Model
constant-growth model
A widely cited dividend
valuation approach that assumes
that dividends will grow at a
constant rate, but a rate that is
less than the required return.
The most widely cited dividend valuation approach, the constant-growth model,
assumes that dividends will grow at a constant rate, but a rate that is less than the
required return. (The assumption that the constant rate of growth, g, is less than
the required return, ks, is a necessary mathematical condition for deriving this
model.5) By letting D0 represent the most recent dividend, we can rewrite Equation 7.2 as follows:
D0 (1 g)1
D0 (1 g)2 . . . D0 (1 g)∞
P0 1
(1 ks )
(1 ks )2
(1 ks )∞
(7.4)
5. Another assumption of the constant-growth model as presented is that earnings and dividends grow at the same
rate. This assumption is true only in cases in which a firm pays out a fixed percentage of its earnings each year (has
a fixed payout ratio). In the case of a declining industry, a negative growth rate ( g < 0%) might exist. In such a case,
the constant-growth model, as well as the variable-growth model presented in the next section, remains fully applicable to the valuation process.
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If we simplify Equation 7.4, it can be rewritten as6
Gordon model
A common name for the
constant-growth model that is
widely cited in dividend
valuation.
EXAMPLE
D1
P0 ks g
(7.5)
The constant-growth model in Equation 7.5 is commonly called the Gordon
model. An example will show how it works.
Lamar Company, a small cosmetics company, from 1998 through 2003 paid the
following per-share dividends:
Year
Dividend per share
2003
$1.40
2002
1.29
2001
1.20
2000
1.12
1999
1.05
1998
1.00
We assume that the historical compound annual growth rate of dividends is an
accurate estimate of the future constant annual rate of dividend growth, g. Using
Appendix Table A–2 or a financial calculator, we find that the historical compound annual growth rate of Lamar Company dividends equals 7%.7 The com-
6. For the interested reader, the calculations necessary to derive Equation 7.5 from Equation 7.4 follow. The first
step is to multiply each side of Equation 7.4 by (1 ks)/(1 g) and subtract Equation 7.4 from the resulting expression. This yields
P0 (1 ks )
D0 (1 g)∞
P0 D0 1g
(1 ks)∞
(1)
Because ks is assumed to be greater than g, the second term on the right side of Equation 1 should be zero. Thus
P0
1 ks
1 D
1g
(2)
0
Equation 2 is simplified as follows:
P0
(1 ks ) (1 g)
D
1g
(3)
0
P0 (ks g) D0
(1 g)
D1
P0 ks g
(4)
(5)
Equation 5 equals Equation 7.5.
7. The technique involves solving the following equation for g:
D2003 D1998
Input
1.00
Function
PV
1.40
FV
5
N
CPT
I
Solution
6.96
(1 g)5
D1998
1
PVIFg,5
(1 g)5
D2003
To do so, we can use financial tables or a financial calculator.
Two basic steps can be followed using the present value table. First, dividing the earliest dividend (D1998 $1.00)
by the most recent dividend (D2003 $1.40) yields a factor for the present value of one dollar, PVIF, of 0.714 ($1.00
$1.40). Although six dividends are shown, they reflect only 5 years of growth. (The number of years of growth can
also be found by subtracting the earliest year from the most recent year—that is, 2003 1998 5 years of growth.)
By looking across the Appendix Table A–2 at the PVIF for 5 years, we find that the factor closest to 0.714 occurs at
7% (0.713). Therefore, the growth rate of the dividends, rounded to the nearest whole percent, is 7%.
Alternatively, a financial calculator can be used. (Note: Most calculators require either the PV or FV value to
be input as a negative number to calculate an unknown interest or growth rate. That approach is used here.) Using
the inputs shown at the left, you should find the growth rate to be 6.96%, which we round to 7%.
CHAPTER 7
Stock Valuation
327
pany estimates that its dividend in 2004, D1, will equal $1.50. The required
return, ks, is assumed to be 15%. By substituting these values into Equation 7.5,
we find the value of the stock to be
$1.50
$1.50
P0 $
1
8
.7
5
per share
0.15 0.07
0.08
Assuming that the values of D1, ks, and g are accurately estimated, Lamar Company’s stock value is $18.75 per share.
Variable-Growth Model
variable-growth model
A dividend valuation approach
that allows for a change in the
dividend growth rate.
The zero- and constant-growth common stock models do not allow for any shift
in expected growth rates. Because future growth rates might shift up or down
because of changing expectations, it is useful to consider a variable-growth model
that allows for a change in the dividend growth rate.8 We will assume that a single shift in growth rates occurs at the end of year N, and we will use g1 to represent the initial growth rate and g2 for the growth rate after the shift. To determine
the value of a share of stock in the case of variable growth, we use a four-step
procedure.
Step 1
Find the value of the cash dividends at the end of each year, Dt, during the
initial growth period, years 1 through N. This step may require adjusting
the most recent dividend, D0, using the initial growth rate, g1, to calculate
the dividend amount for each year. Therefore, for the first N years,
Dt D0
(1 g1)t D0
FVIFg
1,t
Step 2 Find the present value of the dividends expected during the initial growth
period. Using the notation presented earlier, we can give this value as
N
N
N
D0 (1 g1)
Dt
(Dt
t
(1
k
)
(1
ks )t
s
t
t
1
t
1
t
1
PVIFks ,t)
Step 3 Find the value of the stock at the end of the initial growth period,
PN (DN1)/(ks g2), which is the present value of all dividends expected from year N 1 to infinity, assuming a constant dividend growth
rate, g2. This value is found by applying the constant-growth model
(Equation 7.5) to the dividends expected from year N 1 to infinity. The
present value of PN would represent the value today of all dividends that
are expected to be received from year N 1 to infinity. This value can be
represented by
1
(1 ks )N
DN1
PVIFks ,N
ks g2
PN
8. More than one change in the growth rate can be incorporated into the model, but to simplify the discussion we will
consider only a single growth-rate change. The number of variable-growth valuation models is technically unlimited,
but concern over all possible shifts in growth is unlikely to yield much more accuracy than a simpler model.
328
PART 2
Important Financial Concepts
Step 4 Add the present value components found in Steps 2 and 3 to find the
value of the stock, P0, given in Equation 7.6:
N
D0 (1 g1)t
1
P0 t
(1
k
)
(1
ks )N
s
t1
DN 1
ks g2
Present value of
dividends
during initial
growth period
(7.6)
Present value of
price of stock
at end of initial
growth period
The following example illustrates the application of these steps to a variablegrowth situation with only one change in growth rate.
EXAMPLE
The most recent (2003) annual dividend payment of Warren Industries, a rapidly
growing boat manufacturer, was $1.50 per share. The firm’s financial manager
expects that these dividends will increase at a 10% annual rate, g1, over the next
3 years (2004, 2005, and 2006) because the introduction of a hot new boat. At
the end of the 3 years (the end of 2006), the firm’s mature product line is
expected to result in a slowing of the dividend growth rate to 5% per year, g2, for
the foreseeable future. The firm’s required return, ks, is 15%. To estimate the current (end-of-2003) value of Warren’s common stock, P0 P2003, the four-step
procedure must be applied to these data.
Step 1 The value of the cash dividends in each of the next 3 years is calculated
in columns 1, 2, and 3 of Table 7.3. The 2004, 2005, and 2006 dividends are $1.65, $1.82, and $2.00, respectively.
Step 2 The present value of the three dividends expected during the 2004–2006
initial growth period is calculated in columns 3, 4, and 5 of Table 7.3.
The sum of the present values of the three dividends is $4.14.
Step 3 The value of the stock at the end of the initial growth period (N 2006)
can be found by first calculating DN1 D2007:
D2007 D2006
(1 0.05) $2.00
(1.05) $2.10
T A B L E 7 . 3 Calculation of Present Value of Warren Industries
Dividends (2004–2006)
Present value
of dividends
[(3) (4)]
(5)
t
End of
year
D0 D2003
(1)
FVIF10%,t
(2)
Dt
[(1) (2)]
(3)
1
2004
$1.50
1.100
$1.65
0.870
$1.44
2
2005
1.50
1.210
1.82
0.756
1.38
3
2006
1.50
1.331
2.00
PVIF15%,t
(4)
0.658
1
.3
2
D0 (1 g1)t
Sum of present value of dividends $4
.1
4
(1 ks )t
t1
3
CHAPTER 7
Stock Valuation
329
By using D2007 $2.10, a 15% required return, and a 5% dividend
growth rate, we can calculate the value of the stock at the end of 2006 as
follows:
D2007
$2.10
$2.10
P2006 $21.00
ks g2
0.15 0.05
0.10
Finally, in Step 3, the share value of $21 at the end of 2006 must be converted into a present (end-of-2003) value. Using the 15% required return,
we get
PVIFks ,N
PN PVIF15%,3
P2006 0.658
$21.00 $13.82
Step 4 Adding the present value of the initial dividend stream (found in Step 2)
to the present value of the stock at the end of the initial growth period
(found in Step 3) as specified in Equation 7.6, we get the current (end-of2003) value of Warren Industries stock:
P2003 $4.14 $13.82 $17.96 per share
The stock is currently worth $17.96 per share. The calculation of this
value is depicted graphically on the following time line.
Time line for finding
Warren Industries
current (end-of-2003)
value with variable
growth
2003
2004
D2004 = $1.65
Present Value
of Dividends
During Initial
Period = $4.14
Present Value
of Stock Price
at End of
Initial Period
End of Year
2005
2006
D2005 = $1.82
D2006 = $2.00
$ 1.44
1.38
1.32
13.82
P2003 = $17.96
PVIF15%, 1 × $1.65 = 0.870 × $1.65
PVIF15%, 2 × $1.82 = 0.756 × $1.82
PVIF15%, 3 × $2.00 = 0.658 × $2.00
PVIF15%, 3 × $21.00 = 0.658 × $21.00
P2006 =
D2007
$2.10
=
= $21.00
ks – g2 0.15 – 0.05
The zero-, constant-, and variable-growth valuation models provide useful
frameworks for estimating stock value. Clearly, the estimates produced cannot be
very precise, given that the forecasts of future growth and discount rates are
themselves necessarily approximate. Furthermore, a great deal of measurement
error can be introduced into the stock price estimate as a result of the imprecise
and rounded growth and discount rate estimates used as inputs. When applying
valuation models, it is therefore advisable to estimate these rates carefully and
round them conservatively, probably to the nearest tenth of a percent.
Free Cash Flow Valuation Model
As an alternative to the dividend valuation models presented above, a firm’s value
can be estimated by using its projected free cash flows (FCFs). This approach is
appealing when one is valuing firms that have no dividend history or are startups
or when one is valuing an operating unit or division of a larger public company.
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FOCUS ON e-FINANCE
What’s the Value of the American Dream?
For many people, owning their own
business represents the dream of
a lifetime. But how much should
this dream cost? To get an idea of
how to value a small business,
check out the “Business for Sale”
column in Inc., a magazine that
focuses on smaller emerging businesses. Each month the column
describes the operations, financial
situation, industry outlook, price
rationale, and pros and cons of a
small business offered for sale. For
example, columns featured in 2000
and 2001 included such diverse
companies as a distributor of semiprecious stones, a software developer, a Christmas tree grower, a
small chain of used-book stores,
and a baseball camp, with prices
ranging from $200,000 to $9 million.
Most valuations are based on a
multiple of cash flow or annual
sales, with accepted guidelines for
different industries. That number is
free cash flow valuation model
A model that determines the
value of an entire company as the
present value of its expected free
cash flows discounted at the
firm’s weighted average cost of
capital, which is its expected
average future cost of funds over
the long run.
just a starting point, however, and
must be adjusted for other factors.
For example, food distributors
typically sell for about 30 percent
of annual sales. A Southeastern
seafood distributor was recently
offered for $2.25 million, a discount
from the $3.9 million price you’d
get strictly on the basis of annual
sales. The reason? The new owner
would have to buy or lease a warehouse facility, freezers, and other
equipment.
Because valuing a small business is difficult, many owners
make use of reasonably priced valuation software such as BallPark
Business Valuation and VALUware.
These programs offer buyers and
sellers a quick way to estimate the
business’s value and to answer
such questions as:
• How much cash will my business generate or consume?
In Practice
• What will my balance sheet,
income statement, and cash
flow statement look like in 5
years?
• Should I seek debt or equity
to finance growth?
• What impact will capital purchases have on my venture?
• How much ownership in my
business should I give up for a
$2 million equity contribution?
Once the negotiators decide
to move forward, however, they
usually should hire an experienced
valuation professional to develop a
formal valuation.
Sources: “About Ballpark Business Valuation,” Bullet Proof Business Plans, downloaded from www.bulletproofbizplans.com/
BallPark/About_/about_.html; Jill Andresky
Fraser, “Business for Sale: Southeastern
Seafood Distributor,” Inc. (October 1, 2000),
downloaded from www.inc.com; VALUware,
www.bizbooksoftware.com/VALUWARE.
HTM.
Although dividend valuation models are widely used and accepted, in these situations it is preferable to use a more general free cash flow valuation model.
The free cash flow valuation model is based on the same basic premise as
dividend valuation models: The value of a share of common stock is the present
value of all future cash flows it is expected to provide over an infinite time horizon. However, in the free cash flow valuation model, instead of valuing the
firm’s expected dividends, we value the firm’s expected free cash flows, defined
in Equation 3.3 (page 106). They represent the amount of cash flow available to
investors—the providers of debt (creditors) and equity (owners)—after all other
obligations have been met.
The free cash flow valuation model estimates the value of the entire company
by finding the present value of its expected free cash flows discounted at its
weighted average cost of capital, which is its expected average future cost of
funds over the long run (see Chapter 11), as specified in Equation 7.7.
FCF∞
FCF1
FCF2
. . . VC 1
2
(1 ka)
(1 ka)
(1 ka)∞
where
VC value of the entire company
FCFt free cash flow expected at the end of year t
ka the firm’s weighted average cost of capital
(7.7)
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331
Stock Valuation
Note the similarity between Equations 7.7 and 7.2, the general stock valuation
equation.
Because the value of the entire company, VC, is the market value of the entire
enterprise (that is, of all assets), to find common stock value, VS, we must subtract the market value of all of the firm’s debt, VD, and the market value of preferred stock, VP, from VC.
VS VC VD VP
(7.8)
Because it is difficult to forecast a firm’s free cash flow, specific annual cash
flows are typically forecast for only about 5 years, beyond which a constant
growth rate is assumed. Here we assume that the first 5 years of free cash flows
are explicitly forecast and that a constant rate of free cash flow growth occurs
beyond the end of year 5 to infinity.9 This model is methodologically similar to
the variable-growth model presented earlier. Its application is best demonstrated
with an example.
EXAMPLE
Dewhurst Inc. wishes to determine the value of its stock by using the free cash
flow valuation model. In order to apply the model, the firm’s CFO developed the
data given in Table 7.4. Application of the model can be performed in four steps.
Step 1 Calculate the present value of the free cash flow occurring from the end
of 2009 to infinity, measured at the beginning of 2009 (that is, at the end
of 2008). Because a constant rate of growth in FCF is forecast beyond
2008, we can use the constant-growth dividend valuation model (Equation 7.5) to calculate the value of the free cash flows from the end of
2009 to infinity.
Value of FCF2009
∞
FCF2009
ka gFCF
$600,000 (1 0.03)
0.09 0.03
$618,000
$10
,30
0,0
00
0.06
TABLE 7.4
Dewhurst Inc.’s Data for Free Cash Flow
Valuation Model
Free cash flow
Year (t)
(FCFt)a
2004
$400,000
2005
450,000
Weighted average cost of capital, ka 9%
2006
520,000
Market value of all debt, VD $3,100,000
Other data
Growth rate of FCF, beyond 2008 to infinity, gFCF 3%
2007
560,000
Market value of preferred stock, VP $800,000
2008
600,000
Number of shares of common stock outstanding 300,000
aDeveloped
using Equations 3.2 and 3.3 (page 106).
9. The approach demonstrated here is consistent with that found in Alfred Rappaport, Creating Shareholder Value
(New York: The Free Press, 1998). A somewhat similar approach to value can be found in G. Bennett Stewart III,
The Quest for Value (New York: HarperCollins, 1999).
332
PART 2
Important Financial Concepts
Note that to calculate the FCF in 2009, we had to increase the 2008 FCF
value of $600,000 by the 3% FCF growth rate, gFCF.
Step 2 Add the present value of the FCF from 2009 to infinity, which is measured
at the end of 2008, to the 2008 FCF value to get the total FCF in 2008.
Total FCF2008 $600,000 $10,300,000 $10,900,000
Step 3 Find the sum of the present values of the FCFs for 2004 through 2008
to determine the value of the entire company, VC. This calculation is
shown in Table 7.5, using present value interest factors, PVIFs, from
Appendix Table A–2.
Step 4 Calculate the value of the common stock using Equation 7.8. Substituting the value of the entire company, VC , calculated in Step 3, and the
market values of debt, VD , and preferred stock, VP, given in Table 7.4,
yields the value of the common stock, VS :
VS $8,628,620 $3,100,000 $800,000 $4
,7
2
8
,6
2
0
The value of Dewhurst’s common stock is therefore estimated to be
$4,728,620. By dividing this total by the 300,000 shares of common
stock that the firm has outstanding, we get a common stock value of
$15.76 per share ($4,728,620 300,000).
It should now be clear that the free cash flow valuation model is consistent
with the dividend valuation models presented earlier. The appeal of this
approach is its focus on the free cash flow estimates rather than on forecast dividends, which are far more difficult to estimate, given that they are paid at the discretion of the firm’s board. The more general nature of the free cash flow model
is responsible for its growing popularity, particularly with CFOs and other financial managers.
TABLE 7.5
Calculation of the Value of the
Entire Company for Dewhurst Inc.
FCFt
(1)
Year (t)
2004
Present value of FCFt
[(1) (2)]
(3)
400,000
0.917
$ 366,800
2005
450,000
0.842
378,900
2006
520,000
0.772
401,440
0.708
396,480
2007
2008
$
PVIF 9%,t
(2)
560,000
10,900,000a
0.650
7
,0
8
5
,0
0
0
Value of entire company, VC $8
,
6
2
8
,
6
2
0
aThis amount is the sum of the FCF
2008 of $600,000 from Table 7.4 and the
$10,300,000 value of the FCF2009 ∞ calculated in Step 1.
CHAPTER 7
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333
Other Approaches to Common Stock Valuation
Many other approaches to common stock valuation exist. The more popular
approaches include book value, liquidation value, and some type of price/earnings
multiple.
Book Value
book value per share
The amount per share of common
stock that would be received if all
of the firm’s assets were sold for
their exact book (accounting)
value and the proceeds remaining
after paying all liabilities (including preferred stock) were divided
among the common stockholders.
EXAMPLE
Book value per share is simply the amount per share of common stock that
would be received if all of the firm’s assets were sold for their exact book
(accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders. This method
lacks sophistication and can be criticized on the basis of its reliance on historical
balance sheet data. It ignores the firm’s expected earnings potential and generally
lacks any true relationship to the firm’s value in the marketplace. Let us look at
an example.
At year-end 2003, Lamar Company’s balance sheet shows total assets of $6 million, total liabilities (including preferred stock) of $4.5 million, and 100,000
shares of common stock outstanding. Its book value per share therefore would be
$6,000,000 $4,500,000
$15 per share
100,000 shares
Because this value assumes that assets could be sold for their book value, it may
not represent the minimum price at which shares are valued in the marketplace.
As a matter of fact, although most stocks sell above book value, it is not unusual
to find stocks selling below book value when investors believe either that assets
are overvalued or that the firm’s liabilities are understated.
liquidation value per share
The actual amount per share of
common stock that would be
received if all of the firm’s assets
were sold for their market value,
liabilities (including preferred
stock) were paid, and any
remaining money were divided
among the common stockholders.
EXAMPLE
Liquidation Value
Liquidation value per share is the actual amount per share of common stock that
would be received if all of the firm’s assets were sold for their market value, liabilities (including preferred stock) were paid, and any remaining money were divided
among the common stockholders.10 This measure is more realistic than book
value—because it is based on the current market value of the firm’s assets—but it
still fails to consider the earning power of those assets. An example will illustrate.
Lamar Company found upon investigation that it could obtain only $5.25 million if it sold its assets today. The firm’s liquidation value per share therefore
would be
$5,250,000 $4,500,000
$7.50 per share
100,000 shares
Ignoring liquidation expenses, this amount would be the firm’s minimum value.
10. In the event of liquidation, creditors’ claims must be satisfied first, then those of the preferred stockholders.
Anything left goes to common stockholders. A more detailed discussion of liquidation procedures is presented in
Chapter 17.
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PART 2
Important Financial Concepts
Price/Earnings (P/E) Multiples
price/earnings multiple approach
A popular technique used to
estimate the firm’s share value;
calculated by multiplying the
firm’s expected earnings per
share (EPS) by the average
price/earnings (P/E) ratio for the
industry.
EXAMPLE
Hint From an investor’s
perspective, the stock in this
situation would be an attractive
investment only if it could be
purchased at a price below its
liquidation value—which in an
efficient market could never
occur.
The price/earnings (P/E) ratio, introduced in Chapter 2, reflects the amount
investors are willing to pay for each dollar of earnings. The average P/E ratio in a
particular industry can be used as the guide to a firm’s value—if it is assumed that
investors value the earnings of that firm in the same way they do the “average”
firm in the industry. The price/earnings multiple approach is a popular technique
used to estimate the firm’s share value; it is calculated by multiplying the firm’s
expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the
industry. The average P/E ratio for the industry can be obtained from a source
such as Standard & Poor’s Industrial Ratios.
The use of P/E multiples is especially helpful in valuing firms that are not
publicly traded, whereas market price quotations can be used to value publicly
traded firms.11 In any case, the price/earnings multiple approach is considered
superior to the use of book or liquidation values because it considers expected
earnings.12 An example will demonstrate the use of price/earnings multiples.
Lamar Company is expected to earn $2.60 per share next year (2004). This
expectation is based on an analysis of the firm’s historical earnings trend and of
expected economic and industry conditions. The average price/earnings (P/E)
ratio for firms in the same industry is 7. Multiplying Lamar’s expected earnings
per share (EPS) of $2.60 by this ratio gives us a value for the firm’s shares of
$18.20, assuming that investors will continue to measure the value of the average
firm at 7 times its earnings.
So how much is Lamar Company’s stock really worth? That’s a trick question, because there’s no one right answer. It is important to recognize that the
answer depends on the assumptions made and the techniques used. Professional
securities analysts typically use a variety of models and techniques to value
stocks. For example, an analyst might use the constant-growth model, liquidation
value, and price/earnings (P/E) multiples to estimate the worth of a given stock. If
the analyst feels comfortable with his or her estimates, the stock would be valued
at no more than the largest estimate. Of course, should the firm’s estimated liquidation value per share exceed its “going concern” value per share, estimated by
using one of the valuation models (zero-, constant-, or variable-growth or free
cash flow) or the P/E multiple approach, the firm would be viewed as being
“worth more dead than alive.” In such an event, the firm would lack sufficient
earning power to justify its existence and should probably be liquidated.
11. Generally, when the P/E ratio is used to value privately owned or closely owned corporations, a premium is
added to adjust for the issue of control. This adjustment is necessary because the P/E ratio implicitly reflects minority interests of noncontrolling investors in publicly owned companies—a condition that does not exist in privately or
closely owned corporations.
12. The price/earnings multiple approach to valuation does have a theoretical explanation. If we view 1 divided by
the price/earnings ratio, or the earnings/price ratio, as the rate at which investors discount the firm’s earnings, and if
we assume that the projected earnings per share will be earned indefinitely (i.e., no growth in earnings per share), the
price/earnings multiple approach can be looked on as a method of finding the present value of a perpetuity of projected earnings per share at a rate equal to the earnings/price ratio. This method is in effect a form of the zerogrowth model presented in Equation 7.3 on page 325.
CHAPTER 7
Stock Valuation
335
Review Questions
7–13 Describe the events that occur in an efficient market in response to new
information that causes the expected return to exceed the required return.
What happens to the market value?
7–14 What does the efficient-market hypothesis say about (a) securities prices,
(b) their reaction to new information, and (c) investor opportunities to
profit?
7–15 Describe, compare, and contrast the following common stock dividend
valuation models: (a) zero-growth, (b) constant-growth, and (c) variablegrowth.
7–16 Describe the free cash flow valuation model and explain how it differs
from the dividend valuation models. What is the appeal of this model?
7–17 Explain each of the three other approaches to common stock valuation:
(a) book value, (b) liquidation value, and (c) price/earnings (P/E) multiples. Which of these is considered the best?
LG6
7.4 Decision Making and Common Stock Value
Valuation equations measure the stock value at a point in time based on expected
return and risk. Any decisions of the financial manager that affect these variables
can cause the value of the firm to change. Figure 7.4 depicts the relationship
among financial decisions, return, risk, and stock value.
Changes in Expected Return
Assuming that economic conditions remain stable, any management action that
would cause current and prospective stockholders to raise their dividend expectations should increase the firm’s value. In Equation 7.5,13 we can see that P0 will
FIGURE 7.4
Decision Making
and Stock Value
Financial decisions, return,
risk, and stock value
Decision
Action by
Financial
Manager
Effect on
1. Expected Return
Measured by Expected
Dividends, D1, D2, …, Dn,
and Expected Dividend
Growth, g.
2. Risk Measured by the
Required Return, ks.
Effect on
Stock Value
D1
P0 =
ks – g
13. To convey the interrelationship among financial decisions, return, risk, and stock value, the constant-growth
model is used. Other models—zero-growth, variable-growth, or free cash flow—could be used, but the simplicity of
exposition using the constant-growth model justifies its use here.
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Important Financial Concepts
increase for any increase in D1 or g. Any action of the financial manager that will
increase the level of expected returns without changing risk (the required return)
should be undertaken, because it will positively affect owners’ wealth.
EXAMPLE
Using the constant-growth model, we found Lamar Company to have a share
value of $18.75. On the following day, the firm announced a major technological breakthrough that would revolutionize its industry. Current and prospective stockholders would not be expected to adjust their required return of 15%,
but they would expect that future dividends will increase. Specifically, they
expect that although the dividend next year, D1, will remain at $1.50, the
expected rate of growth thereafter will increase from 7% to 9%. If we substitute D1 $1.50, ks 0.15, and g 0.09 into Equation 7.5, the resulting value is
$25 [$1.50 (0.15 0.09)]. The increased value therefore resulted from the
higher expected future dividends reflected in the increase in the growth rate.
Changes in Risk
Although ks is defined as the required return, we know from Chapter 5 that it is
directly related to the nondiversifiable risk, which can be measured by beta. The
capital asset pricing model (CAPM) given in Equation 5.8 is restated here as
Equation 7.9:
ks RF [b
(km RF)]
(7.9)
With the risk-free rate, RF, and the market return, km, held constant, the
required return, ks, depends directly on beta. Any action taken by the financial
manager that increases risk (beta) will also increase the required return. In Equation 7.5, we can see that with everything else constant, an increase in the required
return, ks, will reduce share value, P0. Likewise, a decrease in the required return
will increase share value. Thus any action of the financial manager that increases
risk contributes to a reduction in value, and any action that decreases risk contributes to an increase in value.
EXAMPLE
Assume that Lamar Company’s 15% required return resulted from a risk-free
rate of 9%, a market return of 13%, and a beta of 1.50. Substituting into the capital asset pricing model, Equation 7.9, we get a required return, ks, of 15%:
ks 9% [1.50
(13% 9%)] 15%
With this return, the value of the firm was calculated in the example above to be
$18.75.
Now imagine that the financial manager makes a decision that, without
changing expected dividends, causes the firm’s beta to increase to 1.75. Assuming
that RF and km remain at 9% and 13%, respectively, the required return will
increase to 16% (9% [1.75 (13% 9%)]) to compensate stockholders for the
increased risk. Substituting D1 $1.50, ks 0.16, and g 0.07 into the valuation
equation, Equation 7.5, results in a share value of $16.67 [$1.50 (0.16 0.07)]. As expected, raising the required return, without any corresponding
increase in expected return, causes the firm’s stock value to decline. Clearly, the
financial manager’s action was not in the owners’ best interest.
CHAPTER 7
Stock Valuation
337
Combined Effect
A financial decision rarely affects return and risk independently; most decisions
affect both factors. In terms of the measures presented, with an increase in
risk (b), one would expect an increase in return (D1 or g, or both), assuming that
RF and km remain unchanged. The net effect on value depends on the size of the
changes in these variables.
EXAMPLE
If we assume that the two changes illustrated for Lamar Company in the preceding examples occur simultaneously, key variable values would be D1 $1.50,
ks 0.16, and g 0.09. Substituting into the valuation model, we obtain a share
price of $21.43 [$1.50 (0.16 0.09)]. The net result of the decision, which
increased return (g, from 7% to 9%) as well as risk (b, from 1.50 to 1.75 and
therefore ks from 15% to 16%), is positive: The share price increased from
$18.75 to $21.43. The decision appears to be in the best interest of the firm’s
owners, because it increases their wealth.
Review Questions
7–18 Explain the linkages among financial decisions, return, risk, and stock
value.
7–19 Assuming that all other variables remain unchanged, what impact would
each of the following have on stock price? (a) The firm’s beta increases.
(b) The firm’s required return decreases. (c) The dividend expected next
year decreases. (d) The rate of growth in dividends is expected to
increase.
S U M M A RY
FOCUS ON VALUE
The price of each share of a firm’s common stock is the value of each ownership interest.
Although common stockholders typically have voting rights, which indirectly give them a
say in management, their only significant right is their claim on the residual cash flows of
the firm. This claim is subordinate to those of vendors, employees, customers, lenders, the
government (for taxes), and preferred stockholders. The value of the common stockholders’
claim is embodied in the cash flows they are entitled to receive from now to infinity. The
present value of those expected cash flows is the firm’s share value.
To determine this present value, cash flows are discounted at a rate that reflects the
riskiness of the forecast cash flows. Riskier cash flows are discounted at higher rates, resulting in lower present values than less risky expected cash flows, which are discounted at
338
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Important Financial Concepts
lower rates. The value of the firm’s common stock is therefore driven by its expected cash
flows (returns) and risk (certainty of the expected cash flows).
In pursuing the firm’s goal of maximizing the stock price, the financial manager must
carefully consider the balance of return and risk associated with each proposal and must
undertake only those that create value for owners—that is, increase share price. By focusing on value creation and by managing and monitoring the firm’s cash flows and risk, the
financial manager should be able to achieve the firm’s goal of share price maximization.
REVIEW OF LEARNING GOALS
Differentiate between debt and equity capital.
Holders of equity capital (common and preferred
stock) are owners of the firm. Typically, only common
stockholders have a voice in management through their
voting rights. Equity holders have claims on income
and assets that are secondary to the claims of creditors,
there is no maturity date, and the firm does not benefit
from tax deductibility of dividends paid to stockholders, as is the case for interest paid to debtholders.
LG1
Discuss the rights, characteristics, and features
of both common and preferred stock. The common stock of a firm can be privately owned, closely
owned, or publicly owned. It can be sold with or
without a par value. Preemptive rights allow common stockholders to avoid dilution of ownership
when new shares are issued. Not all shares authorized in the corporate charter are outstanding. If a
firm has treasury stock, it will have issued more
shares than are outstanding. Some firms have two or
more classes of common stock that differ mainly in
having unequal voting rights. Proxies transfer voting
rights from one party to another. Dividend distributions to common stockholders are made at the discretion of the firm’s board of directors. Firms can issue stock in foreign markets. The stock of many
foreign corporations is traded in the form of American depositary receipts (ADRs) in U.S. markets.
Preferred stockholders have preference over
common stockholders with respect to the distribution of earnings and assets and so are normally not
given voting privileges. Preferred stock issues may
have certain restrictive covenants, cumulative dividends, a call feature, and a conversion feature.
LG2
LG3
Describe the process of issuing common stock,
including in your discussion venture capital, go-
ing public, the investment banker’s role, and stock
quotations. The initial nonfounder financing for
business startups with attractive growth prospects
typically comes from private equity investors. These
investors can be either angel capitalists or venture
capitalists (VCs), which are more formal business
entities. Institutional VCs can be organized in a
number of ways, but the VC limited partnership is
the most common. VCs usually invest in both earlystage and later-stage companies that they hope to
take public in order to cash out their investments.
The first public issue of a firm’s stock is called
an initial public offering (IPO). The company selects
an investment banker to advise it and to sell the
securities. The lead investment banker may form a
selling syndicate with other investment bankers to
sell the issue. The IPO process includes filing a registration statement with the Securities and Exchange
Commission (SEC), getting SEC approval, promoting the offering to investors, pricing the issue, and
selling the shares.
Stock quotations, published regularly in the
financial media, provide information on stocks, including calendar year change in price, 52-week high
and low, dividend, dividend yield, P/E ratio, volume, latest price, and net price change from the
prior trading day.
Understand the concept of market efficiency
and basic common stock valuation under each
of three cases: zero growth, constant growth, and
variable growth. Market efficiency, which is
assumed throughout the text, suggests that there are
many rational investors whose quick reactions to
new information cause the market value of common
stock to adjust upward or downward depending
upon whether the expected return is above or
LG4
CHAPTER 7
Stock Valuation
339
below, respectively, the required return for the
period. The efficient-market hypothesis suggests
that securities are fairly priced, that they reflect
fully all publicly available information, and that
investors should therefore not waste time trying to
find and capitalize on mispriced securities. The
value of a share of common stock is the present
value of all future dividends it is expected to provide over an infinite time horizon. Three dividend
growth models—zero-growth, constant-growth,
and variable-growth—can be considered in common stock valuation. The basic stock valuation
equation and these models are summarized in
Table 7.6. The most widely cited model is the constant-growth model.
Book value per share is the amount per share of
common stock that would be received if all of the
firm’s assets were sold for their book (accounting)
value and the proceeds remaining after paying all
liabilities (including preferred stock) were divided
among the common stockholders. Liquidation value
per share is the actual amount per share of common
stock that would be received if all of the firm’s
assets were sold for their market value, liabilities
(including preferred stock) were paid, and the
remaining money were divided among the common
stockholders. The price/earnings (P/E) multiples
approach estimates stock value by multiplying the
firm’s expected earnings per share (EPS) by the
average price/earnings (P/E) ratio for the industry.
Discuss the free cash flow valuation model and
the use of book value, liquidation value, and
price/earnings (P/E) multiples to estimate common
stock values. The free cash flow valuation model is
appealing when one is valuing firms that have no
dividend history, startups, or operating units or divisions of a larger public company. The model finds
the value of the entire company by discounting the
firm’s expected free cash flow at its weighted average cost of capital. The common stock value is
found by subtracting the market values of the firm’s
debt and preferred stock from the value of the entire
company. The two equations involved in this model
are summarized in Table 7.6.
Explain the relationships among financial decisions, return, risk, and the firm’s value. In a stable economy, any action of the financial manager
that increases the level of expected return without
changing risk should increase share value, and any
action that reduces the level of expected return without changing risk should reduce share value. Similarly, any action that increases risk (required return)
will reduce share value, and any action that reduces
risk will increase share value. Because most financial
decisions affect both return and risk, an assessment
of their combined effect on stock value must be part
of the financial decision-making process.
LG5
SELF-TEST PROBLEMS
LG6
(Solutions in Appendix B)
LG4
ST 7–1
Common stock valuation Perry Motors’ common stock currently pays an
annual dividend of $1.80 per share. The required return on the common stock is
12%. Estimate the value of the common stock under each of the following
assumptions about the dividend.
a. Dividends are expected to grow at an annual rate of 0% to infinity.
b. Dividends are expected to grow at a constant annual rate of 5% to infinity.
c. Dividends are expected to grow at an annual rate of 5% for each of the next 3
years, followed by a constant annual growth rate of 4% in years 4 to infinity.
LG5
ST 7–2
Free cash flow valuation Erwin Footwear wishes to assess the value of its
Active Shoe Division. This division has debt with a market value of $12,500,000
and no preferred stock. Its weighted average cost of capital is 10%. The Active
340
PART 2
Important Financial Concepts
TABLE 7.6
Summary of Key Valuation Definitions and
Formulas for Common Stock
Definitions of variables
Dt per-share dividend expected at the end of year t
FCFt free cash flow expected at the end of year t
g constant rate of growth in dividends
g1 initial dividend growth rate (in variable-growth model)
g2 subsequent dividend growth rate (in variable-growth model)
ka weighted average cost of capital
ks required return on common stock
N last year of initial growth period (in variable-growth model)
P0 value of common stock
VC value of the entire company
VD market value of all the firm’s debt
VP market value of preferred stock
VS value of common stock
Valuation formulas
Basic stock value:
D∞
D1
D2
P0 . . . (1 ks)1
(1 ks)2
(1 ks)∞
[Eq. 7.2]
D1
(also used to value preferred stock)
P0 ks
[Eq. 7.3]
D1
P0 ks g
[Eq. 7.5]
Common stock value:
Zero-growth:
Constant-growth:
Variable-growth:
N
D0 (1 g1)t
1
P0 (1 ks)t
(1 ks)N
t1
DN1
ks g2
[Eq. 7.6]
FCF value of entire company:
FCF∞
FCF1
FCF2
VC . . . (1 ka)1
(1 ka)2
(1 ka)∞
[Eq. 7.7]
FCF common stock value:
VS VC VD VP
[Eq. 7.8]
CHAPTER 7
Stock Valuation
341
Shoe Division’s estimated free cash flow each year from 2004 through 2007 is
given in the accompanying table. Beyond 2007 to infinity, the firm expects its
free cash flow to grow at 4% annually.
Year (t)
Free cash flow (FCFt)
2004
$ 800,000
2005
1,200,000
2006
1,400,000
2007
1,500,000
a. Use the free cash flow valuation model to estimate the value of Erwin’s
Active Shoe Division.
b. Use your finding in part a along with the data provided above to find this
division’s common stock value.
c. If the Active Shoe Division as a public company will have 500,000 shares
outstanding, use your finding in part b to calculate its value per share.
PROBLEMS
LG2
7–1
Authorized and available shares Aspin Corporation’s charter authorizes
issuance of 2,000,000 shares of common stock. Currently, 1,400,000 shares are
outstanding and 100,000 shares are being held as treasury stock. The firm
wishes to raise $48,000,000 for a plant expansion. Discussions with its investment bankers indicate that the sale of new common stock will net the firm $60
per share.
a. What is the maximum number of new shares of common stock that the firm
can sell without receiving further authorization from shareholders?
b. Judging on the basis of the data given and your finding in part a, will the firm
be able to raise the needed funds without receiving further authorization?
c. What must the firm do to obtain authorization to issue more than the number of shares found in part a?
LG2
7–2
Preferred dividends Slater Lamp Manufacturing has an outstanding issue of
preferred stock with an $80 par value and an 11% annual dividend.
a. What is the annual dollar dividend? If it is paid quarterly, how much will be
paid each quarter?
b. If the preferred stock is noncumulative and the board of directors has
passed the preferred dividend for the last 3 quarters, how much must be
paid to preferred stockholders before dividends are paid to common
stockholders?
c. If the preferred stock is cumulative and the board of directors has passed the
preferred dividend for the last 3 quarters, how much must be paid to preferred stockholders before dividends are paid to common stockholders?
LG2
7–3
Preferred dividends In each case in the following table, how many dollars of
preferred dividends per share must be paid to preferred stockholders before common stock dividends are paid?
342
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Important Financial Concepts
Case
Type
Par value
$ 80
Dividend per
share per period
$ 5
Periods of
dividends passed
A
Cumulative
B
Noncumulative
110
C
Noncumulative
100
D
Cumulative
60
8.5%
4
E
Cumulative
90
9%
0
8%
$11
2
3
1
LG2
7–4
Convertible preferred stock Valerian Corp. convertible preferred stock has a
fixed conversion ratio of 5 common shares per 1 share of preferred stock. The
preferred stock pays a dividend of $10.00 per share per year. The common
stock currently sells for $20.00 per share and pays a dividend of $1.00 per share
per year.
a. Judging on the basis of the conversion ratio and the price of the common
shares, what is the current conversion value of each preferred share?
b. If the preferred shares are selling at $96.00 each, should an investor convert
the preferred shares to common shares?
c. What factors might cause an investor not to convert from preferred to
common?
LG2
7–5
Stock quotation Assume that the following quote for the Advanced Business
Machines stock (traded on the NYSE) was found in the Thursday, December 14,
issue of the Wall Street Journal.
3.2 84.13 51.25 AdvBusMach ABM 1.32 1.6 23 12432 81.75 1.63
Given this information, answer the following questions:
a. On what day did the trading activity occur?
b. At what price did the stock sell at the end of the day on Wednesday,
December 13?
c. What percentage change has occurred in the stock’s last price since the beginning of the calendar year?
d. What is the firm’s price/earnings ratio? What does it indicate?
e. What is the last price at which the stock traded on the day quoted?
f. How large a dividend is expected in the current year?
g. What are the highest and the lowest price at which the stock traded during
the latest 52-week period?
h. How many shares of stock were traded on the day quoted?
i. How much, if any, of a change in stock price took place between the day
quoted and the day before? At what price did the stock close on the day before?
LG4
7–6
Common stock valuation—Zero growth Scotto Manufacturing is a mature
firm in the machine tool component industry. The firm’s most recent common
stock dividend was $2.40 per share. Because of its maturity as well as its stable
sales and earnings, the firm’s management feels that dividends will remain at the
current level for the foreseeable future.
a. If the required return is 12%, what will be the value of Scotto’s common
stock?
b. If the firm’s risk as perceived by market participants suddenly increases,
causing the required return to rise to 20%, what will be the common stock
value?
CHAPTER 7
Stock Valuation
343
c. Judging on the basis of your findings in parts a and b, what impact does risk
have on value? Explain.
LG4
7–7
Common stock value—Zero growth Kelsey Drums, Inc., is a well-established
supplier of fine percussion instruments to orchestras all over the United States.
The company’s class A common stock has paid a dividend of $5.00 per share per
year for the last 15 years. Management expects to continue to pay at that rate
for the foreseeable future. Sally Talbot purchased 100 shares of Kelsey class A
common 10 years ago at a time when the required rate of return for the stock
was 16%. She wants to sell her shares today. The current required rate of return
for the stock is 12%. How much capital gain or loss will she have on her shares?
LG4
7–8
Preferred stock valuation Jones Design wishes to estimate the value of its outstanding preferred stock. The preferred issue has an $80 par value and pays an
annual dividend of $6.40 per share. Similar-risk preferred stocks are currently
earning a 9.3% annual rate of return.
a. What is the market value of the outstanding preferred stock?
b. If an investor purchases the preferred stock at the value calculated in part a,
how much does she gain or lose per share if she sells the stock when the
required return on similar-risk preferreds has risen to 10.5%? Explain.
LG4
7–9
Common stock value—Constant growth Use the constant-growth model
(Gordon model) to find the value of each firm shown in the following table.
Firm
Dividend expected next year
Dividend growth rate
A
$1.20
B
4.00
5
15
C
0.65
10
14
D
6.00
8
9
E
2.25
8
20
8%
Required return
13%
LG4
7–10
Common stock value—Constant growth McCracken Roofing, Inc., common
stock paid a dividend of $1.20 per share last year. The company expects earnings and dividends to grow at a rate of 5% per year for the foreseeable future.
a. What required rate of return for this stock would result in a price per share
of $28?
b. If McCracken had both earnings growth and dividend growth at a rate of
10%, what required rate of return would result in a price per share of $28?
LG4
7–11
Common stock value—Constant growth Elk County Telephone has paid the
dividends shown in the following table over the past 6 years.
Year
Dividend per share
2003
$2.87
2002
2.76
2001
2.60
2000
2.46
1999
2.37
1998
2.25
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PART 2
Important Financial Concepts
The firm’s dividend per share next year is expected to be $3.02.
a. If you can earn 13% on similar-risk investments, what is the most you would
be willing to pay per share?
b. If you can earn only 10% on similar-risk investments, what is the most you
would be willing to pay per share?
c. Compare and contrast your findings in parts a and b, and discuss the impact
of changing risk on share value.
LG4
7–12
Common stock value—Variable growth Newman Manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just completed,
Grips earned $4.25 per share and paid cash dividends of $2.55 per share (D0 $2.55). Grips’ earnings and dividends are expected to grow at 25% per year for
the next 3 years, after which they are expected to grow at 10% per year to infinity. What is the maximum price per share that Newman should pay for Grips if
it has a required return of 15% on investments with risk characteristics similar
to those of Grips?
LG4
7–13
Common stock value—Variable growth Home Place Hotels, Inc., is entering
into a 3-year remodeling and expansion project. The construction will have a
limiting effect on earnings during that time, but when it is complete, it should
allow the company to enjoy much improved growth in earnings and dividends.
Last year, the company paid a dividend of $3.40. It expects zero growth in the
next year. In years 2 and 3, 5% growth is expected, and in year 4, 15% growth.
In year 5 and thereafter, growth should be a constant 10% per year. What is the
maximum price per share that an investor who requires a return of 14% should
pay for Home Place Hotels common stock?
LG4
7–14
Common stock value—Variable growth Lawrence Industries’ most recent
annual dividend was $1.80 per share (D0 $1.80), and the firm’s required
return is 11%. Find the market value of Lawrence’s shares when:
a. Dividends are expected to grow at 8% annually for 3 years, followed by a
5% constant annual growth rate in years 4 to infinity.
b. Dividends are expected to grow at 8% annually for 3 years, followed by a
0% constant annual growth rate in years 4 to infinity.
c. Dividends are expected to grow at 8% annually for 3 years, followed by a
10% constant annual growth rate in years 4 to infinity.
LG4
7–15
Common stock value—All growth models You are evaluating the potential
purchase of a small business currently generating $42,500 of after-tax cash flow
(D0 $42,500). On the basis of a review of similar-risk investment opportunities, you must earn an 18% rate of return on the proposed purchase. Because
you are relatively uncertain about future cash flows, you decide to estimate the
firm’s value using several possible assumptions about the growth rate of cash
flows.
a. What is the firm’s value if cash flows are expected to grow at an annual rate
of 0% from now to infinity?
b. What is the firm’s value if cash flows are expected to grow at a constant
annual rate of 7% from now to infinity?
c. What is the firm’s value if cash flows are expected to grow at an annual rate
of 12% for the first 2 years, followed by a constant annual rate of 7% from
year 3 to infinity?
CHAPTER 7
LG5
7–16
Stock Valuation
345
Free cash flow valuation Nabor Industries is considering going public but is
unsure of a fair offering price for the company. Before hiring an investment
banker to assist in making the public offering, managers at Nabor have decided
to make their own estimate of the firm’s common stock value. The firm’s CFO
has gathered data for performing the valuation using the free cash flow valuation model.
The firm’s weighted average cost of capital is 11%, and it has $1,500,000 of
debt at market value and $400,000 of preferred stock at its assumed market
value. The estimated free cash flows over the next 5 years, 2004 through 2008,
are given below. Beyond 2008 to infinity, the firm expects its free cash flow to
grow by 3% annually.
Year (t)
Free cash flow (FCFt)
2004
$200,000
2005
250,000
2006
310,000
2007
350,000
2008
390,000
a. Estimate the value of Nabor Industries’ entire company by using the free cash
flow valuation model.
b. Use your finding in part a, along with the data provided above, to find Nabor
Industries’ common stock value.
c. If the firm plans to issue 200,000 shares of common sock, what is its estimated value per share?
LG5
7–17
Using the free cash flow valuation model to price an IPO Assume that you have
an opportunity to buy the stock of CoolTech, Inc., an IPO being offered for
$12.50 per share. Although you are very much interested in owning the company,
you are concerned about whether it is fairly priced. In order to determine the
value of the shares, you have decided to apply the free cash flow valuation model
to the firm’s financial data that you’ve developed from a variety of data sources.
The key values you have compiled are summarized in the following table.
Free cash flow
Year (t)
FCFt
Other data
700,000
Growth rate of FCF, beyond 2007 to infinity 2%
2005
800,000
Weighted average cost of capital 8%
2006
950,000
Market value of all debt $2,700,000
2007
1,100,000
2004
$
Market value of preferred stock $1,000,000
Number of shares of common stock outstanding 1,100,000
a. Use the free cash flow valuation model to estimate CoolTech’s common stock
value per share.
b. Judging on the basis of your finding in part a and the stock’s offering price,
should you buy the stock?
346
PART 2
Important Financial Concepts
c. Upon further analysis, you find that the growth rate in FCF beyond 2007 will
be 3% rather than 2%. What effect would this finding have on your
responses in parts a and b?
LG5
7–18
Book and liquidation value The balance sheet for Gallinas Industries is as
follows.
Gallinas Industries
Balance Sheet
December 31
Assets
Liabilities and Stockholders’ Equity
Cash
$ 40,000
Marketable securities
Accounts receivable
Inventories
Total current assets
Land and buildings (net)
Machinery and equipment
Total fixed assets (net)
Total assets
Accounts payable
$100,000
60,000
Notes payable
30,000
120,000
Accrued wages
160,000
$
3
8
0
,0
0
0
$150,000
Long-term debt
3
0
,0
0
0
$160,000
$1
8
0
,0
0
0
250,000
$
4
0
0
,0
0
0
Total current liabilities
Preferred stock
$ 80,000
Common stock (10,000 shares)
Total liabilities and stockholders’ equity
$
7
8
0
,0
0
0
360,000
$7
8
0
,0
0
0
Additional information with respect to the firm is available:
(1) Preferred stock can be liquidated at book value.
(2) Accounts receivable and inventories can be liquidated at 90% of book value.
(3) The firm has 10,000 shares of common stock outstanding.
(4) All interest and dividends are currently paid up.
(5) Land and buildings can be liquidated at 130% of book value.
(6) Machinery and equipment can be liquidated at 70% of book value.
(7) Cash and marketable securities can be liquidated at book value.
Given this information, answer the following:
a. What is Gallinas Industries’ book value per share?
b. What is its liquidation value per share?
c. Compare, contrast, and discuss the values found in parts a and b.
LG5
7–19
Valuation with price/earnings multiples For each of the firms shown in the following table, use the data given to estimate their common stock value employing
price/earnings (P/E) multiples.
Firm
Expected EPS
Price/earnings multiple
A
$3.00
6.2
B
4.50
10.0
C
1.80
12.6
D
2.40
8.9
E
5.10
15.0
CHAPTER 7
LG4
347
LG6
7–20
Management action and stock value REH Corporation’s most recent dividend
was $3 per share, its expected annual rate of dividend growth is 5%, and the
required return is now 15%. A variety of proposals are being considered by
management to redirect the firm’s activities. Determine the impact on share price
for each of the following proposed actions, and indicate the best alternative.
a. Do nothing, which will leave the key financial variables unchanged.
b. Invest in a new machine that will increase the dividend growth rate to 6%
and lower the required return to 14%.
c. Eliminate an unprofitable product line, which will increase the dividend
growth rate to 7% and raise the required return to 17%.
d. Merge with another firm, which will reduce the growth rate to 4% and raise
the required return to 16%.
e. Acquire a subsidiary operation from another manufacturer. The acquisition
should increase the dividend growth rate to 8% and increase the required
return to 17%.
LG6
7–21
Integrative—Valuation and CAPM formulas Given the following information
for the stock of Foster Company, calculate its beta.
Current price per share of common
Expected dividend per share next year
Constant annual dividend growth rate
Risk-free rate of return
Return on market portfolio
LG4
Stock Valuation
LG6
7–22
$50.00
$ 3.00
9%
7%
10%
Integrative—Risk and valuation Giant Enterprises has a beta of 1.20, the riskfree rate of return is currently 10%, and the market return is 14%. The company, which plans to pay a dividend of $2.60 per share in the coming year,
anticipates that its future dividends will increase at an annual rate consistent
with that experienced over the 1997–2003 period, when the following dividends
were paid:
Year
Dividend per share
2003
$2.45
2002
2.28
2001
2.10
2000
1.95
1999
1.82
1998
1.80
1997
1.73
a. Use the capital asset pricing model (CAPM) to determine the required return
on Giant’s stock.
b. Using the constant-growth model and your finding in part a, estimate the
value of Giant’s stock.
c. Explain what effect, if any, a decrease in beta would have on the value of
Giant’s stock.
348
PART 2
LG4
LG6
Important Financial Concepts
7–23
Integrative—Valuation and CAPM Hamlin Steel Company wishes to determine the value of Craft Foundry, a firm that it is considering acquiring for cash.
Hamlin wishes to use the capital asset pricing model (CAPM) to determine the
applicable discount rate to use as an input to the constant-growth valuation
model. Craft’s stock is not publicly traded. After studying the betas of firms similar to Craft that are publicly traded, Hamlin believes that an appropriate beta
for Craft’s stock would be 1.25. The risk-free rate is currently 9%, and the market return is 13%. Craft’s dividend per share for each of the past 6 years is
shown in the following table.
Year
Dividend per share
2003
$3.44
2002
3.28
2001
3.15
2000
2.90
1999
2.75
1998
2.45
a. Given that Craft is expected to pay a dividend of $3.68 next year, determine
the maximum cash price that Hamlin should pay for each share of Craft.
b. Discuss the use of the CAPM for estimating the value of common stock, and
describe the effect on the resulting value of Craft of:
(1) A decrease in its dividend growth rate of 2% from that exhibited over the
1998–2003 period.
(2) A decrease in its beta to 1.
CHAPTER 7 CASE
Assessing the Impact of Suarez Manufacturing’s
Proposed Risky Investment on Its Stock Value
E
arly in 2004, Inez Marcus, the chief financial officer for Suarez Manufacturing, was given the task of assessing the impact of a proposed risky investment
on the firm’s stock value. To perform the necessary analysis, Inez gathered the following information on the firm’s stock.
During the immediate past 5 years (1999–2003), the annual dividends paid
on the firm’s common stock were as follows:
Year
Dividend per share
2003
$1.90
2002
1.70
2001
1.55
2000
1.40
1999
1.30
The firm expects that without the proposed investment, the dividend in 2004
will be $2.09 per share and the historical annual rate of growth (rounded to the
nearest whole percent) will continue in the future. Currently, the required return
on the common stock is 14%. Inez’s research indicates that if the proposed
CHAPTER 7
Stock Valuation
349
investment is undertaken, the 2004 dividend will rise to $2.15 per share and the
annual rate of dividend growth will increase to 13%. She feels that in the best
case, the dividend would continue to grow at this rate each year into the future
and that in the worst case, the 13% annual rate of growth in dividends would
continue only through 2006, and then, at the beginning of 2007, would return
to the rate that was experienced between 1999 and 2003. As a result of the
increased risk associated with the proposed risky investment, the required return
on the common stock is expected to increase by 2% to an annual rate of 16%,
regardless of which dividend growth outcome occurs.
Armed with the preceding information, Inez must now assess the impact of
the proposed risky investment on the market value of Suarez’s stock. To simplify
her calculations, she plans to round the historical growth rate in common stock
dividends to the nearest whole percent.
Required
a. Find the current value per share of Suarez Manufacturing’s common stock.
b. Find the value of Suarez’s common stock in the event that it undertakes the
proposed risky investment and assuming that the dividend growth rate stays
at 13% forever. Compare this value to that found in part a. What effect
would the proposed investment have on the firm’s stockholders? Explain.
c. On the basis of your findings in part b, do the stockholders win or lose as a
result of undertaking the proposed risky investment? Should the firm do
it? Why?
d. Rework parts b and c assuming that at the beginning of 2007 the annual dividend growth rate returns to the rate experienced between 1999 and 2003.
WEB EXERCISE
WW
W
To use the price/earnings multiples approach to valuation, you need to find a
firm’s projected earnings and the P/E multiple. One of the most popular sites to
obtain these estimates is Zacks Investment Research, www.zacks.com.
1. At the top of the page, locate the area where you can enter a company’s
ticker symbol and select the desired information.
2. Enter OO for Oakley Inc. and select estimates from the pull-down menu.
a. What is the current mean/consensus estimate for the next fiscal year’s
earnings?
b. Using the indicated price/earnings ratio further down on that page, calculate the stock price.
3. Repeat steps 2a and b for the following stocks:
a. Southwest Airlines: LUV
b. Microsoft: MSFT
c. Weight Watchers: WTW
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
I N T E G R AT I V E
C A S E
2
Encore International
n the world of trendsetting fashion, instinct and marketing savvy are
prerequisites to success. Jordan Ellis had both. During 2003, his international casual-wear company, Encore, rocketed to $300 million in sales
after 10 years in business. His fashion line covered the young woman
from head to toe with hats, sweaters, dresses, blouses, skirts, pants,
sweatshirts, socks, and shoes. In Manhattan, there was an Encore shop
every five or six blocks, each featuring a different color. Some shops
showed the entire line in mauve, and others featured it in canary yellow.
Encore had made it. The company’s historical growth was so spectacular that no one could have predicted it. However, securities analysts
speculated that Encore could not keep up the pace. They warned that
competition is fierce in the fashion industry and that the firm might
encounter little or no growth in the future. They estimated that stockholders also should expect no growth in future dividends.
Contrary to the conservative securities analysts, Jordan Ellis felt that
the company could maintain a constant annual growth rate in dividends
per share of 6% in the future, or possibly 8% for the next 2 years and 6%
thereafter. Ellis based his estimates on an established long-term expansion plan into European and Latin American markets. Venturing into
these markets was expected to cause the risk of the firm, as measured by
beta, to increase immediately from 1.10 to 1.25.
In preparing the long-term financial plan, Encore’s chief financial
officer has assigned a junior financial analyst, Marc Scott, to evaluate the
firm’s current stock price. He has asked Marc to consider the conservative predictions of the securities analysts and the aggressive predictions
of the company founder, Jordan Ellis.
Marc has compiled these 2003 financial data to aid his analysis:
I
Data item
Earnings per share (EPS)
Price per share of common stock
2003 value
$6.25
$40.00
Book value of common stock equity $60,000,000
350
Total common shares outstanding
2,500,000
Common stock dividend per share
$4.00
Figure 1
Required Return, k (%)
Security Market Line
30
Data Points
b
k
0.00
6.00%
0.25
8.00
0.50
10.00
0.75
12.00
1.00
14.00
1.25
16.00
1.50
18.00
1.75
20.00
2.00
22.00
25
20
15
10
5
0
.5
1.0
1.5
2.0
2.5
3.0
Nondiversifiable Risk, b
Required
a. What is the firm’s current book value per share?
b. What is the firm’s current P/E ratio?
c. (1) What are the required return and risk premium for Encore stock using
the capital asset pricing model, assuming a beta of 1.10? (Hint: Use the
security market line—with data points noted—given in Figure 1 to find
the market return.)
(2) What are the required return and risk premium for Encore stock using
the capital asset pricing model, assuming a beta of 1.25?
(3) What will be the effect on the required return if the beta rises as
expected?
d. If the securities analysts are correct and there is no growth in future dividends, what will be the value per share of the Encore stock? (Note: Beta 1.25.)
e. (1) If Jordan Ellis’s predictions are correct, what will be the value per share
of Encore stock if the firm maintains a constant annual 6% growth rate
in future dividends? (Note: Beta 1.25.)
(2) If Jordan Ellis’s predictions are correct, what will be the value per share
of Encore stock if the firm maintains a constant annual 8% growth rate
in dividends per share over the next 2 years and 6% thereafter? (Note:
Beta 1.25.)
f. Compare the current (2003) price of the stock and the stock values found in
parts a, d, and e. Discuss why these values may differ. Which valuation
method do you believe most clearly represents the true value of the Encore
stock?
351
CHAPTER
8
CAPITAL BUDGETING
CASH FLOWS
L E A R N I N G
LG1
LG2
LG3
Understand the key motives for capital expenditure and the steps in the capital budgeting
process.
Define basic capital budgeting terminology.
Discuss the major components of relevant
cash flows, expansion versus replacement cash
flows, sunk costs and opportunity costs, and
international capital budgeting and long-term
investments.
G O A L S
LG4
Calculate the initial investment associated with a
proposed capital expenditure.
LG5
Determine relevant operating cash inflows using
the income statement format.
LG6
Find the terminal cash flow.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand capital budgeting cash
flows in order to provide revenue, cost, depreciation, and tax
data for use both in monitoring existing projects and in developing cash flows for proposed projects.
Information systems: You need to understand capital budgeting cash flows in order to maintain and facilitate the retrieval of
cash flow data for both completed and existing projects.
Management: You need to understand capital budgeting cash
flows so that you will understand what cash flows are relevant
in making decisions about proposals for acquiring additional
354
production facilities, for new products, and for the expansion of
existing product lines.
Marketing: You need to understand capital budgeting cash
flows so that you can make revenue estimates for proposals for
new marketing programs, for new products, and for the expansion of existing product lines.
Operations: You need to understand capital budgeting cash
flows so that you can make cost estimates for proposals
for the acquisition of new equipment and production
facilities.
INTEL
CHIPPING AWAY
AT E-BUSINESS
INVESTMENT ANALYSIS
t should come as no surprise that Intel,
the world’s largest chip maker and
technology pioneer, is also a leader in ebusiness. Chairman Andy Grove decided
in 1998 that Intel would transform itself
into a “100 percent e-corporation.” Since then, each of the company’s new business applications
has been based on the Internet or on e-commerce. Leading the Internet initiative was CFO Andy
Bryant, whose responsibilities were expanded to include enterprise services.
Bryant was an unlikely choice to lead the company’s transformation, because he was skeptical about the value of e-commerce. He quickly changed his tune when he learned that Intel
receives over one-quarter of its orders after hours. The flexibility of online ordering added value
for customers. Intel has launched more than 300 e-business projects since 1998. In 2001, the company generated 90 percent of its revenue—$31.4 billion—from e-commerce transactions.
Ironically, Bryant’s skepticism about e-commerce turned out to be a good thing. He developed methods to analyze e-business proposals to make sure they added value to the company,
applying rigorous financial discipline and monitoring returns on investment. “Every project has an
ROI,” Bryant says. “It isn’t always positive, but you still have to measure what you put in and what
you get back.”
The difficulty comes in deciding what to measure—and how. Like most companies, Intel
already had expertise in evaluating new manufacturing facilities and other capital projects. But
technology projects also have intangible benefits that aren’t easily quantified. One of Bryant’s
challenges was formalizing financial accountability for e-business applications.
The company’s track record has been quite good so far. E-business projects have reduced
costs in many areas. For example, an electronic accounts payable (A/P) system was devised to
take over many routine transactions so that employees could focus on analysis. Bryant estimates that the present value of this project’s cash inflows, less the initial investment, is $8 million. And the company no longer misses opportunities to take advantage of discounts for prompt
payments.
Like Intel, every firm must evaluate the costs and returns of projects for expansion, asset
replacement or renewal, research and development, advertising, and other areas that require
long-term commitments of funds in expectation of future returns. Chapter 8 introduces this
process, which is called capital budgeting, and explains how to identify the relevant cash outflows and inflows that must be considered in making capital budgeting decisions.
I
355
356
PART 3
LG1
Long-Term Investment Decisions
LG2
8.1 The Capital Budgeting Decision Process
capital budgeting
The process of evaluating and
selecting long-term investments
that are consistent with the
firm’s goal of maximizing owner
wealth.
Long-term investments represent sizable outlays of funds that commit a firm to
some course of action. Consequently, the firm needs procedures to analyze and
properly select its long-term investments. It must be able to measure cash flows
and apply appropriate decision techniques. As time passes, fixed assets may
become obsolete or may require an overhaul; at these points, too, financial decisions may be required. Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing
owner wealth. Firms typically make a variety of long-term investments, but the
most common for the manufacturing firm is in fixed assets, which include property (land), plant, and equipment. These assets, often referred to as earning
assets, generally provide the basis for the firm’s earning power and value.
Because firms treat capital budgeting (investment) and financing decisions
separately, Chapters 8 through 10 concentrate on fixed-asset acquisition without regard to the specific method of financing used. We begin by discussing the
motives for capital expenditure.
Motives for Capital Expenditure
capital expenditure
An outlay of funds by the firm that
is expected to produce benefits
over a period of time greater than
1 year.
operating expenditure
An outlay of funds by the firm
resulting in benefits received
within 1 year.
A capital expenditure is an outlay of funds by the firm that is expected to produce
benefits over a period of time greater than 1 year. An operating expenditure is an
outlay resulting in benefits received within 1 year. Fixed-asset outlays are capital
expenditures, but not all capital expenditures are classified as fixed assets. A
$60,000 outlay for a new machine with a usable life of 15 years is a capital
expenditure that would appear as a fixed asset on the firm’s balance sheet. A
$60,000 outlay for advertising that produces benefits over a long period is also a
capital expenditure, but would rarely be shown as a fixed asset.1
Capital expenditures are made for many reasons. The basic motives for capital expenditures are to expand, replace, or renew fixed assets or to obtain some
other, less tangible benefit over a long period. Table 8.1 briefly describes the key
motives for making capital expenditures.
Steps in the Process
capital budgeting process
Five distinct but interrelated
steps: proposal generation,
review and analysis, decision
making, implementation, and
follow-up.
The capital budgeting process consists of five distinct but interrelated steps.
1. Proposal generation. Proposals are made at all levels within a business organization and are reviewed by finance personnel. Proposals that require large
outlays are more carefully scrutinized than less costly ones.
2. Review and analysis. Formal review and analysis is performed to assess the
appropriateness of proposals and evaluate their economic viability. Once the
analysis is complete, a summary report is submitted to decision makers.
1. Some firms do, in effect, capitalize advertising outlays if there is reason to believe that the benefit of the outlay
will be received at some future date. The capitalized advertising may appear as a deferred charge such as “deferred
advertising expense,” which is then amortized over the future. Expenses of this type are often deferred for reporting
purposes to increase reported earnings, whereas for tax purposes, the entire amount is expensed to reduce tax
liability.
CHAPTER 8
TABLE 8.1
Capital Budgeting Cash Flows
357
Key Motives for Making Capital Expenditures
Motive
Description
Expansion
The most common motive for a capital expenditure is to expand the level
of operations—usually through acquisition of fixed assets. A growing
firm often needs to acquire new fixed assets rapidly, as in the purchase
of property and plant facilities.
Replacement
As a firm’s growth slows and it reaches maturity, most capital expenditures will be made to replace or renew obsolete or worn-out assets. Each
time a machine requires a major repair, the outlay for the repair should
be compared to the outlay to replace the machine and the benefits of
replacement.
Renewal
Renewal, an alternative to replacement, may involve rebuilding, overhauling, or retrofitting an existing fixed asset. For example, an existing
drill press could be renewed by replacing its motor and adding a numeric
control system, or a physical facility could be renewed by rewiring and
adding air conditioning. To improve efficiency, both replacement and
renewal of existing machinery may be suitable solutions.
Other purposes
Some capital expenditures do not result in the acquisition or transformation of tangible fixed assets. Instead, they involve a long-term commitment of funds in expectation of a future return. These expenditures
include outlays for advertising, research and development, management
consulting, and new products. Other capital expenditure proposals—such
as the installation of pollution-control and safety devices mandated by
the government—are difficult to evaluate because they provide intangible
returns rather than clearly measurable cash flows.
3. Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar limits. Generally, the board of directors must authorize expenditures beyond a certain amount. Often plant managers are given
authority to make decisions necessary to keep the production line moving.
4. Implementation. Following approval, expenditures are made and projects
implemented. Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored, and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones.
Each step in the process is important. Review and analysis and decision making (Steps 2 and 3) consume the majority of time and effort, however. Follow-up
(Step 5) is an important but often ignored step aimed at allowing the firm to
improve the accuracy of its cash flow estimates continuously. Because of their
fundamental importance, this and the following chapters give primary consideration to review and analysis and to decision making.
Basic Terminology
Before we develop the concepts, techniques, and practices related to the capital
budgeting process, we need to explain some basic terminology. In addition, we
will present some key assumptions that are used to simplify the discussion in the
remainder of this chapter and in Chapters 9 and 10.
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FOCUS ON e-FINANCE
Information Technology’s Big Byte
Information technology (IT) is one
of a company’s largest capital expense categories. In the rapidly
changing IT environment, managers clamor for the latest hardware and software upgrades to
keep IT systems current and improve operational efficiencies. The
right IT applications, they claim,
can save millions in operating
costs. Financial managers, on the
other hand, struggle to control
capital spending while at the same
time approving projects that boost
the company’s competitive position. Although some of these projects involve the latest hardware
and software, many more now focus on leveraging the firm’s investment in existing technology by
centralizing technology services,
integrating the different parts of a
company’s information systems,
and making similar improvements.
E-business projects are also on
the rise and now account for an
average of 15.5 percent of the total
IT budget.
With so much at stake in
terms of dollars spent and potential benefits, managers must create a business case that justifies
the project and shows how it adds
value—no easy task. In addition to
measuring dollar benefits that appear on the firm’s income statement, they must attempt to quantify
indirect and qualitative benefits.
This may be straightforward for
transactional systems, where order volume is a critical measure.
But how does the company assign
a dollar value to, for example, the
increased customer satisfaction
generated by a new, easier-to-use
interface for its customer information system?
During 2001, declining sales
and an uncertain economic future
meant companies had to choose IT
projects that yielded the greatest
return on investment or gave the
biggest strategic advantage. Gary
Clark, director of corporate IT services at La-Z-Boy Inc., the leading
U.S. manufacturer of upholstered
In Practice
furniture, said, “Previously, we
would look primarily at high-level
issues. Now, we’re not only examining the details of a project but
also the underlying assumptions
and the business case. It’s all
about cost and results.” La-Z-Boy
decided to postpone projects related to information security and
general business systems but
moved ahead with strategic technology projects. For example,
analysis of a new payroll and human resources system showed
that it should lower costs for the
entire organization.
Sources: Shari Caudron, “The Tao of
E-Business,” Business Finance
(September 2001), downloaded from
www.businessfinance.com; Sam Greengard,
“IT: Luxury or Necessity?” Industry Week
(December 1, 2001), downloaded from
www. industryweek.com; and Ivy
McLemore, “High Stakes Game,” Business
Finance (May 1999), downloaded from
www.businessfinance.com.
Independent versus Mutually Exclusive Projects
independent projects
Projects whose cash flows are
unrelated or independent of one
another; the acceptance of one
does not eliminate the others
from further consideration.
mutually exclusive projects
Projects that compete with one
another, so that the acceptance
of one eliminates from further
consideration all other projects
that serve a similar function.
unlimited funds
The financial situation in which
a firm is able to accept all
independent projects that
provide an acceptable return.
The two most common types of projects are (1) independent projects and (2)
mutually exclusive projects. Independent projects are those whose cash flows are
unrelated or independent of one another; the acceptance of one does not eliminate the others from further consideration. Mutually exclusive projects are those
that have the same function and therefore compete with one another. The acceptance of one eliminates from further consideration all other projects that serve a
similar function. For example, a firm in need of increased production capacity
could obtain it by (1) expanding its plant, (2) acquiring another company, or (3)
contracting with another company for production. Clearly, accepting any one
option eliminates the need for either of the others.
Unlimited Funds versus Capital Rationing
The availability of funds for capital expenditures affects the firm’s decisions. If a
firm has unlimited funds for investment, making capital budgeting decisions is
quite simple: All independent projects that will provide an acceptable return can
CHAPTER 8
capital rationing
The financial situation in which
a firm has only a fixed number of
dollars available for capital
expenditures, and numerous
projects compete for these
dollars.
359
Capital Budgeting Cash Flows
be accepted. Typically, though, firms operate under capital rationing instead.
This means that they have only a fixed number of dollars available for capital
expenditures and that numerous projects will compete for these dollars. Procedures for dealing with capital rationing are presented in Chapter 10. The discussions that follow here and in the following chapter assume unlimited funds.
Accept–Reject versus Ranking Approaches
accept–reject approach
The evaluation of capital
expenditure proposals to
determine whether they meet the
firm’s minimum acceptance
criterion.
ranking approach
The ranking of capital expenditure projects on the basis of
some predetermined measure,
such as the rate of return.
Two basic approaches to capital budgeting decisions are available. The accept–
reject approach involves evaluating capital expenditure proposals to determine
whether they meet the firm’s minimum acceptance criterion. This approach can
be used when the firm has unlimited funds, as a preliminary step when evaluating
mutually exclusive projects, or in a situation in which capital must be rationed. In
these cases, only acceptable projects should be considered.
The second method, the ranking approach, involves ranking projects on the
basis of some predetermined measure, such as the rate of return. The project with
the highest return is ranked first, and the project with the lowest return is ranked
last. Only acceptable projects should be ranked. Ranking is useful in selecting the
“best” of a group of mutually exclusive projects and in evaluating projects with a
view to capital rationing.
Conventional versus Nonconventional Cash Flow Patterns
conventional cash flow pattern
An initial outflow followed only
by a series of inflows.
nonconventional
cash flow pattern
An initial outflow followed by a
series of inflows and outflows.
Cash flow patterns associated with capital investment projects can be classified as
conventional or nonconventional. A conventional cash flow pattern consists of
an initial outflow followed only by a series of inflows. For example, a firm may
spend $10,000 today and as a result expect to receive equal annual cash inflows
(an annuity) of $2,000 each year for the next 8 years, as depicted on the time line
in Figure 8.1.2 A conventional cash flow pattern that provides unequal annual
cash inflows is depicted in Figure 8.3 on page 361.
A nonconventional cash flow pattern is one in which an initial outflow is followed by a series of inflows and outflows. For example, the purchase of a machine
FIGURE 8.1
Conventional Cash Flow
Time line for a conventional
cash flow pattern
$2,000
$2,000
Cash Inflows
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
0
Cash Outflows
1
2
3
4
5
6
7
8
$10,000
End of Year
2. Arrows rather than plus or minus signs are frequently used on time lines to distinguish between cash inflows and
cash outflows. Upward-pointing arrows represent cash inflows (positive cash flows), and downward-pointing
arrows represent cash outflows (negative cash flows).
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Long-Term Investment Decisions
FIGURE 8.2
Nonconventional
Cash Flow
Time line for a nonconventional cash flow pattern
$5,000
$5,000
$5,000
$5,000
Cash Inflows
0
Cash Outflows
$5,000
$5,000
$5,000
$5,000
$5,000
5
1
2
3
4
$20,000
6
7
8
9
10
$8,000
End of Year
may require an initial cash outflow of $20,000 and may generate cash inflows of
$5,000 each year for 4 years. In the fifth year after purchase, an outflow of $8,000
may be required to overhaul the machine, after which it generates inflows of
$5,000 each year for 5 more years. This nonconventional pattern is illustrated on
the time line in Figure 8.2.
Difficulties often arise in evaluating projects with nonconventional patterns
of cash flow. The discussions in the remainder of this chapter and in Chapters 9
and 10 are therefore limited to the evaluation of conventional cash flow patterns.
Review Questions
8–1
8–2
8–3
8–4
LG3
What is capital budgeting? Do all capital expenditures involve fixed
assets? Explain.
What are the key motives for making capital expenditures? Discuss, compare, and contrast them.
What are the five steps involved in the capital budgeting process?
Differentiate between the members of each of the following pairs of capital budgeting terms: (a) independent versus mutually exclusive projects;
(b) unlimited funds versus capital rationing; (c) accept–reject versus ranking approaches; and (d) conventional versus nonconventional cash flow
patterns.
8.2 The Relevant Cash Flows
relevant cash flows
The incremental cash outflow
(investment) and resulting subsequent inflows associated with a
proposed capital expenditure.
incremental cash flows
The additional cash flows—
outflows or inflows—expected
to result from a proposed capital
expenditure.
To evaluate capital expenditure alternatives, the firm must determine the relevant
cash flows. These are the incremental cash outflow (investment) and resulting
subsequent inflows. The incremental cash flows represent the additional cash
flows—outflows or inflows—expected to result from a proposed capital expenditure. As noted in Chapter 3, cash flows rather than accounting figures are used,
because cash flows directly affect the firm’s ability to pay bills and purchase
assets. The remainder of this chapter is devoted to the procedures for measuring
the relevant cash flows associated with proposed capital expenditures.
CHAPTER 8
Capital Budgeting Cash Flows
361
Major Cash Flow Components
initial investment
The relevant cash outflow for a
proposed project at time zero.
operating cash inflows
The incremental after-tax cash
inflows resulting from implementation of a project during its life.
terminal cash flow
The after-tax nonoperating cash
flow occurring in the final year of
a project. It is usually attributable to liquidation of the project.
The cash flows of any project having the conventional pattern can include three
basic components: (1) an initial investment, (2) operating cash inflows, and (3)
terminal cash flow. All projects—whether for expansion, replacement, renewal,
or some other purpose—have the first two components. Some, however, lack the
final component, terminal cash flow.
Figure 8.3 depicts on a time line the cash flows for a project. The initial investment for the proposed project is $50,000. This is the relevant cash outflow at time
zero. The operating cash inflows, which are the incremental after-tax cash inflows
resulting from implementation of the project during its life, gradually increase
from $4,000 in its first year to $10,000 in its tenth and final year. The terminal
cash flow is the after-tax nonoperating cash flow occurring in the final year of the
project. It is usually attributable to liquidation of the project. In this case it is
$25,000, received at the end of the project’s 10-year life. Note that the terminal
cash flow does not include the $10,000 operating cash inflow for year 10.
Expansion versus Replacement Cash Flows
Developing relevant cash flow estimates is most straightforward in the case of
expansion decisions. In this case, the initial investment, operating cash inflows,
and terminal cash flow are merely the after-tax cash outflow and inflows associated with the proposed capital expenditure.
Identifying relevant cash flows for replacement decisions is more complicated, because the firm must identify the incremental cash outflow and inflows
that would result from the proposed replacement. The initial investment in the
case of replacement is the difference between the initial investment needed to
acquire the new asset and any after-tax cash inflows expected from liquidation of
FIGURE 8.3
Terminal
Cash Flow
Cash Flow Components
Time line for major cash flow
components
$25,000
Operating
Cash Inflows
$5,000
$4,000
$7,000
$6,000
$8,000
$7,000
$8,000
$8,000
$10,000
$9,000
0
1
2
3
4
5
6
$50,000
End of Year
Initial
Investment
7
8
9
10
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Long-Term Investment Decisions
FIGURE 8.4
Relevant Cash Flows for
Replacement Decisions
Calculation of the three
components of relevant cash
flow for a replacement
decision
Initial
investment
Initial investment
needed to acquire
new asset
After-tax cash inflows
from liquidation
of old asset
Operating
cash inflows
Operating cash
inflows from
new asset
Operating cash
inflows from
old asset
Terminal
cash flow
After-tax cash flows
from termination
of new asset
After-tax cash flows
from termination
of old asset
the old asset. The operating cash inflows are the difference between the operating
cash inflows from the new asset and those from the old asset. The terminal cash
flow is the difference between the after-tax cash flows expected upon termination
of the new and the old assets. These relationships are shown in Figure 8.4.
Actually, all capital budgeting decisions can be viewed as replacement decisions. Expansion decisions are merely replacement decisions in which all cash
flows from the old asset are zero. In light of this fact, this chapter focuses primarily on replacement decisions.
Sunk Costs and Opportunity Costs
sunk costs
Cash outlays that have already
been made (past outlays) and
therefore have no effect on the
cash flows relevant to a current
decision.
opportunity costs
Cash flows that could be realized
from the best alternative use of
an owned asset.
EXAMPLE
When estimating the relevant cash flows associated with a proposed capital
expenditure, the firm must recognize any sunk costs and opportunity costs. These
costs are easy to mishandle or ignore, particularly when determining a project’s
incremental cash flows. Sunk costs are cash outlays that have already been made
(past outlays) and therefore have no effect on the cash flows relevant to the current decision. As a result, sunk costs should not be included in a project’s incremental cash flows.
Opportunity costs are cash flows that could be realized from the best alternative use of an owned asset. They therefore represent cash flows that will not be
realized as a result of employing that asset in the proposed project. Because of
this, any opportunity costs should be included as cash outflows when one is
determining a project’s incremental cash flows.
Jankow Equipment is considering renewing its drill press X12, which it purchased
3 years earlier for $237,000, by retrofitting it with the computerized control system from an obsolete piece of equipment it owns. The obsolete equipment could
be sold today for a high bid of $42,000, but without its computerized control system, it would be worth nothing. Jankow is in the process of estimating the labor
CHAPTER 8
FOCUS ON PRACTICE
Coors Brews Better Financial Performance
As Coors Brewing Company grew
from a local brewer to the number3 national brand, it went on a capital spending spree to add capacity.
The firm needed better financial
planning, however: Managers did
not prepare project cost reports,
the company bought top-of-theline equipment, top management
approved projects in spite of unattractive projected returns. By the
early 1990s, Coors’ financial performance was suffering.
This changed in 1995 when
seasoned financial executive Tim
Wolf joined Coors as CFO. Wolf
quickly identified the need for
greater financial discipline in planning and capital budgeting. He
implemented more stringent
guidelines for capital spending
and required business unit managers to develop a sound business
case to justify proposed capital
expenditures. He also created a
partnership between finance and
operating departments, which
Hint Sunk costs and
opportunity costs are
concepts you must fully
understand. Funds already
spent are irrelevant to
future decisions, but funds
given to one project that
eliminates the investment
returns of another project
are considered a relevant
cost.
Capital Budgeting Cash Flows
now recognized the key role that
finance plays.
The first project to use Wolf’s
new capital budgeting procedures
was a facility to wash and sanitize
returnable bottles. Before replacing outdated equipment, managers
analyzed the financial implications
of six operating scenarios to determine the best alternative: moving
the facility to Virginia. Every
department that would be affected
had input into the facility’s design
and into estimates of its operating
costs. The project team presented
the complete business case to
Wolf, who spent 6 months asking
questions that resulted in cutting
over 25 percent from the initial
cost estimates. “I think the extra
time was well spent,” says Wolf.
“If you can reduce your capital
costs, leverage the benefits, and
get them faster, that’s the way to
run your capital process.”
In Wolf’s first 3 years at
Coors, capital spending dropped
363
In Practice
significantly, return on invested
capital rose from 5.9 percent in
1995 to 8.8 percent in late 1997, and
cash flow went from a negative $26
million to a positive $138 million.
The company continued to apply
its disciplined capital budgeting
approach to expansion projects
required to meet a large increase
in demand. By 2000, return on
invested capital was almost 12 percent, and return on equity was
almost 13 percent. The result was
improved shareholder value as the
stock price climbed from $19 in
early 1997 to peak at $82 in December 2000; it was trading at about
$65 a share in March 2002.
Sources: Stephen Barr, “Coors’s New
Brew,” CFO (March 1998), downloaded
from www.cfonet.com; Coors Annual Report,
2000, www.coors.com; “Coors Reports
13 Percent Rise,” AP Online (October 25,
2001), downloaded from Electric Library,
ask.elibrary.com; and John Rebchook,
“Coors Building Expanded Distribution
Facility off I-70,” Denver Rocky Mountain
News (December 19, 2001), p. 4B.
and materials costs of retrofitting the system to drill press X12 and the benefits
expected from the retrofit. The $237,000 cost of drill press X12 is a sunk cost
because it represents an earlier cash outlay. It would not be included as a cash outflow when determining the cash flows relevant to the retrofit decision. Although
Jankow owns the obsolete piece of equipment, the proposed use of its computerized control system represents an opportunity cost of $42,000—the highest price
at which it could be sold today. This opportunity cost would be included as a cash
outflow associated with using the computerized control system.
International Capital Budgeting
and Long-Term Investments
Although the same basic capital budgeting principles are used for domestic and
international projects, several additional factors must be addressed in evaluating
foreign investment opportunities. International capital budgeting differs from the
domestic version because (1) cash outflows and inflows occur in a foreign currency, and (2) foreign investments entail potentially significant political risk. Both
of these risks can be minimized through careful planning.
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Long-Term Investment Decisions
foreign direct investment
The transfer of capital, managerial, and technical assets to a
foreign country.
Companies face both long-term and short-term currency risks related to both
the invested capital and the cash flows resulting from it. Long-term currency risk
can be minimized by financing the foreign investment at least partly in the local
capital markets rather than with dollar-denominated capital from the parent
company. This step ensures that the project’s revenues, operating costs, and
financing costs will be in the local currency. Likewise, the dollar value of shortterm, local-currency cash flows can be protected by using special securities and
strategies such as futures, forwards, and options market instruments.
Political risks can be minimized by using both operating and financial strategies. For example, by structuring the investment as a joint venture and selecting a
well-connected local partner, the U.S. company can minimize the risk of its operations being seized or harassed. Companies also can protect themselves from having their investment returns blocked by local governments by structuring the
financing of such investments as debt rather than as equity. Debt-service payments are legally enforceable claims, whereas equity returns (such as dividends)
are not. Even if local courts do not support the claims of the U.S. company, the
company can threaten to pursue its case in U.S. courts.
In spite of the preceding difficulties, foreign direct investment, which involves
the transfer of capital, managerial, and technical assets to a foreign country, has
surged in recent years. This is evident in the growing market values of foreign
assets owned by U.S.-based companies and of foreign direct investment in the
United States, particularly by British, Canadian, Dutch, German, and Japanese
companies. Furthermore, foreign direct investment by U.S. companies seems to
be accelerating.
Review Questions
8–5
8–6
8–7
8–8
LG4
Why is it important to evaluate capital budgeting projects on the basis of
incremental cash flows?
What three components of cash flow may exist for a given project? How
can expansion decisions be treated as replacement decisions? Explain.
What effect do sunk costs and opportunity costs have on a project’s incremental cash flows?
How can currency risk and political risk be minimized when one is making foreign direct investment?
8.3 Finding the Initial Investment
The term initial investment as used here refers to the relevant cash outflows to be
considered when evaluating a prospective capital expenditure. Because our discussion of capital budgeting is concerned only with investments that exhibit conventional cash flows, the initial investment occurs at time zero—the time at which the
expenditure is made. The initial investment is calculated by subtracting all cash
inflows occurring at time zero from all cash outflows occurring at time zero.
The basic format for determining the initial investment is given in Table 8.2.
The cash flows that must be considered when determining the initial investment
CHAPTER 8
TABLE 8.2
Capital Budgeting Cash Flows
365
The Basic Format
for Determining
Initial Investment
Installed cost of new asset Cost of new asset
Installation costs
After-tax proceeds from sale of old asset Proceeds from sale of old asset
Tax on sale of old asset
Change in net working capital
Initial investment
cost of new asset
The net outflow necessary to
acquire a new asset.
installation costs
Any added costs that are
necessary to place an asset into
operation.
installed cost of new asset
The cost of the asset plus its
installation costs; equals the
asset’s depreciable value.
after-tax proceeds
from sale of old asset
The difference between the old
asset’s sale proceeds and any
applicable taxes or tax refunds
related to its sale.
proceeds from sale of old asset
The cash inflows, net of any
removal or cleanup costs, resulting from the sale of an existing
asset.
tax on sale of old asset
Tax that depends on the relationship among the old asset’s sale
price, initial purchase price, and
book value, and on existing
government tax rules.
associated with a capital expenditure are the installed cost of the new asset, the
after-tax proceeds (if any) from the sale of an old asset, and the change (if any) in
net working capital. Note that if there are no installation costs and the firm is not
replacing an existing asset, then the purchase price of the asset, adjusted for any
change in net working capital, is equal to the initial investment.
Installed Cost of New Asset
As shown in Table 8.2, the installed cost of the new asset is found by adding the
cost of the new asset to its installation costs. The cost of new asset is the net outflow that its acquisition requires. Usually, we are concerned with the acquisition
of a fixed asset for which a definite purchase price is paid. Installation costs are
any added costs that are necessary to place an asset into operation. The Internal
Revenue Service (IRS) requires the firm to add installation costs to the purchase
price of an asset to determine its depreciable value, which is expensed over a
period of years. The installed cost of new asset, calculated by adding the cost of
the asset to its installation costs, equals its depreciable value.
After-Tax Proceeds from Sale of Old Asset
Table 8.2 shows that the after-tax proceeds from sale of old asset decrease the
firm’s initial investment in the new asset. These proceeds are the difference
between the old asset’s sale proceeds and any applicable taxes or tax refunds
related to its sale. The proceeds from sale of old asset are the net cash inflows it provides. This amount is net of any costs incurred in the process of removing the asset.
Included in these removal costs are cleanup costs, such as those related to removal
and disposal of chemical and nuclear wastes. These costs may not be trivial.
The proceeds from the sale of an old asset are normally subject to some type of
tax.3 This tax on sale of old asset depends on the relationship among its sale price,
initial purchase price, and book value, and on existing government tax rules.
3. A brief discussion of the tax treatment of ordinary and capital gains income was presented in Chapter 1.
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book value
The strict accounting value of an
asset, calculated by subtracting
its accumulated depreciation
from its installed cost.
EXAMPLE
Book Value
The book value of an asset is its strict accounting value. It can be calculated by
using the following equation:
Book value Installed cost of asset Accumulated depreciation
(8.1)
Hudson Industries, a small electronics company, 2 years ago acquired a machine
tool with an installed cost of $100,000. The asset was being depreciated under
MACRS using a 5-year recovery period.4 Table 3.2 (page 100) shows that under
MACRS for a 5-year recovery period, 20% and 32% of the installed cost would
be depreciated in years 1 and 2, respectively. In other words, 52% (20% 32%)
of the $100,000 cost, or $52,000 (0.52 $100,000), would represent the accumulated depreciation at the end of year 2. Substituting into Equation 8.1, we get
Book value $100,000 $52,000 $4
8
,0
0
0
The book value of Hudson’s asset at the end of year 2 is therefore $48,000.
Basic Tax Rules
Four potential tax situations can occur when an asset is sold. These situations
depend on the relationship between the asset’s sale price, its initial purchase
price, and its book value. The three key forms of taxable income and their associated tax treatments are defined and summarized in Table 8.3. The assumed tax
rates used throughout this text are noted in the final column. There are four possible tax situations, which result in one or more forms of taxable income: The
TABLE 8.3
Tax Treatment on Sales of Assets
Form of taxable income
Definition
Tax treatment
Assumed tax rate
Capital gain
Portion of the sale price that is in
excess of the initial purchase price.
Regardless of how long the asset
has been held, the total capital gain
is taxed as ordinary income.
40%
Recaptured depreciation
Portion of the sale price that is in
excess of book value and represents
a recovery of previously taken
depreciation.
All recaptured depreciation is taxed
as ordinary income.
40%
Loss on sale of asset
Amount by which sale price is less
than book value.
If the asset is depreciable and used
in business, loss is deducted from
ordinary income.
40% of loss is a
tax savings
If the asset is not depreciable or
is not used in business, loss is
deductible only against capital
gains.
40% of loss is a
tax savings
4. For a review of MACRS, see Chapter 3. Under current tax law, most manufacturing equipment has a 7-year
recovery period, as noted in Table 3.1. Using this recovery period results in 8 years of depreciation, which unnecessarily complicates examples and problems. To simplify, manufacturing equipment is treated as a 5-year asset in this
and the following chapters.
CHAPTER 8
Capital Budgeting Cash Flows
367
asset may be sold (1) for more than its initial purchase price, (2) for more than its
book value but less than its initial purchase price, (3) for its book value, or (4) for
less than its book value. An example will illustrate.
EXAMPLE
recaptured depreciation
The portion of an asset’s sale
price that is above its book
value and below its initial
purchase price.
The old asset purchased 2 years ago for $100,000 by Hudson Industries has a
current book value of $48,000. What will happen if the firm now decides to sell
the asset and replace it? The tax consequences depend on the sale price. Figure
8.5 on page 368 depicts the taxable income resulting from four possible sale
prices in light of the asset’s initial purchase price of $100,000 and its current
book value of $48,000. The taxable consequences of each of these sale prices is
described below.
The sale of the asset for more than its initial purchase price If Hudson sells the
old asset for $110,000, it realizes a capital gain of $10,000, which is taxed as
ordinary income.5 The firm also experiences ordinary income in the form of
recaptured depreciation, which is the portion of the sale price that is above book
value and below the initial purchase price. In this case there is recaptured depreciation of $52,000 ($100,000 $48,000). Both the $10,000 capital gain and the
$52,000 recaptured depreciation are shown under the $110,000 sale price in Figure 8.5. The taxes on the total gain of $62,000 are calculated as follows:
Tax
Amount
(1)
Rate
(2)
[(1) (2)]
(3)
Capital gain
$10,000
0.40
$24,000
Recaptured depreciation
5
2
,0
0
0
$
6
2
,
0
0
0
0.40
2
0
,8
0
0
$
2
4
,
8
0
0
Totals
These taxes should be used in calculating the initial investment in the new asset,
using the format in Table 8.2. In effect, the taxes raise the amount of the firm’s
initial investment in the new asset by reducing the proceeds from the sale of the
old asset.
The sale of the asset for more than its book value but less than its initial purchase
price If Hudson sells the old asset for $70,000, there is no capital gain. However,
the firm still experiences a gain in the form of recaptured depreciation of $22,000
($70,000 $48,000), as shown under the $70,000 sale price in Figure 8.5. This
recaptured depreciation is taxed as ordinary income. Because the firm is assumed
to be in the 40% tax bracket, the taxes on the $22,000 gain are $8,800. This
amount in taxes should be used in calculating the initial investment in the new
asset.
The sale of the asset for its book value If the asset is sold for $48,000, its book
value, the firm breaks even. There is no gain or loss, as shown under the $48,000
5. Although the current tax law requires corporate capital gains to be treated as ordinary income, the structure for
corporate capital gains is retained under the law to facilitate a rate differential in the likely event of future tax revisions. Therefore, this distinction is made throughout the text discussions.
368
PART 3
FIGURE 8.5
Long-Term Investment Decisions
Taxable Income from Sale of Asset
Taxable income from sale of asset at various sale prices for Hudson Industries
Sale Price
$110,000
Initial
Purchase
Price
$110,000
$100,000
$70,000
Book
Value
$48,000
$70,000
$48,000
$30,000
Capital Gain
($10,000)
Recaptured
Depreciation
($52,000)
Recaptured
Depreciation
($22,000)
$30,000
No Gain
or Loss
Loss
($18,000)
$0
sale price in Figure 8.5. Because no tax results from selling an asset for its book
value, there is no tax effect on the initial investment in the new asset.
The sale of the asset for less than its book value If Hudson sells the asset for
$30,000, it experiences a loss of $18,000 ($48,000 $30,000), as shown under
the $30,000 sale price in Figure 8.5. If this is a depreciable asset used in the business, the loss may be used to offset ordinary operating income. If the asset is not
depreciable or is not used in the business, the loss can be used only to offset capital
gains. In either case, the loss will save the firm $7,200 ($18,000 0.40) in taxes.
And, if current operating earnings or capital gains are not sufficient to offset the
loss, the firm may be able to apply these losses to prior or future years’ taxes.6
Change in Net Working Capital7
net working capital
The amount by which a firm’s
current assets exceed its current
liabilities.
Net working capital is the amount by which a firm’s current assets exceed its current liabilities. This topic is treated in depth in Chapter 14, but at this point it is
important to note that changes in net working capital often accompany capital
expenditure decisions. If a firm acquires new machinery to expand its level of
operations, it will experience an increase in levels of cash, accounts receivable,
inventories, accounts payable, and accruals. These increases result from the need
6. As noted in Chapter 1, the tax law provides detailed procedures for using tax loss carrybacks/carryforwards.
Application of such procedures to capital budgeting is beyond the scope of this text, and they are therefore ignored
in subsequent discussions.
7. Occasionally, this cash outflow is intentionally ignored to enhance the attractiveness of a proposed investment
and thereby improve its likelihood of acceptance. Similar intentional omissions and/or overly optimistic estimates
are sometimes made to enhance project acceptance. The presence of formal review and analysis procedures should
help the firm to ensure that capital budgeting cash flow estimates are realistic and unbiased and that the “best” projects—those that make the maximum contribution to owner wealth—are accepted.
CHAPTER 8
TABLE 8.4
Capital Budgeting Cash Flows
Calculation of Change
in Net Working Capital
for Danson Company
Current account
$ 4,000
Accounts receivable
10,000
Inventories
8
,0
0
0
Accounts payable
$ 7,000
Accruals
2
,0
0
0
(2) Current liabilities
Change in net working capital [(1) (2)]
EXAMPLE
Change in balance
Cash
(1) Current assets
change in net working capital
The difference between a change
in current assets and a change in
current liabilities.
369
$22,000
9
,0
0
0
$
1
3
,
0
0
0
for more cash to support expanded operations, more accounts receivable and
inventories to support increased sales, and more accounts payable and accruals to
support increased outlays made to meet expanded product demand. As noted in
Chapter 3, increases in cash, accounts receivable, and inventories are outflows of
cash, whereas increases in accounts payable and accruals are inflows of cash.
The difference between the change in current assets and the change in current
liabilities is the change in net working capital. Generally, current assets increase
by more than current liabilities, resulting in an increased investment in net working capital. This increased investment is treated as an initial outflow.8 If the
change in net working capital were negative, it would be shown as an initial
inflow. The change in net working capital—regardless of whether it is an increase
or a decrease—is not taxable because it merely involves a net buildup or net
reduction of current accounts.
Danson Company, a metal products manufacturer, is contemplating expanding its
operations. Financial analysts expect that the changes in current accounts summarized in Table 8.4 will occur and will be maintained over the life of the expansion.
Current assets are expected to increase by $22,000, and current liabilities are
expected to increase by $9,000, resulting in a $13,000 increase in net working capital. In this case, the increase will represent an increased net working capital investment and will be treated as a cash outflow in calculating the initial investment.
Calculating the Initial Investment
A variety of tax and other considerations enter into the initial investment calculation. The following example illustrates calculation of the initial investment
according to the format in Table 8.2.9
8. When changes in net working capital apply to the initial investment associated with a proposed capital expenditure, they are for convenience assumed to be instantaneous and thereby occurring at time zero. In practice, the change
in net working capital will frequently occur over a period of months as the capital expenditure is implemented.
9. Throughout the discussions of capital budgeting, all assets evaluated as candidates for replacement are assumed
to be depreciable assets that are directly used in the business, so any losses on the sale of these assets can be applied
against ordinary operating income. The decisions are also structured to ensure that the usable life remaining on the
old asset is just equal to the life of the new asset; this assumption enables us to avoid the problem of unequal lives,
which is discussed in Chapter 10.
370
PART 3
Long-Term Investment Decisions
EXAMPLE
Powell Corporation, a large, diversified manufacturer of aircraft components, is
trying to determine the initial investment required to replace an old machine with
a new, more sophisticated model. The machine’s purchase price is $380,000, and
an additional $20,000 will be necessary to install it. It will be depreciated under
MACRS using a 5-year recovery period. The present (old) machine was purchased 3 years ago at a cost of $240,000 and was being depreciated under
MACRS using a 5-year recovery period. The firm has found a buyer willing to
pay $280,000 for the present machine and to remove it at the buyer’s expense.
The firm expects that a $35,000 increase in current assets and an $18,000
increase in current liabilities will accompany the replacement; these changes will
result in a $17,000 ($35,000 $18,000) increase in net working capital. Both
ordinary income and capital gains are taxed at a rate of 40%.
The only component of the initial investment calculation that is difficult to
obtain is taxes. Because the firm is planning to sell the present machine for
$40,000 more than its initial purchase price, a capital gain of $40,000 will be
realized. The book value of the present machine can be found by using the depreciation percentages from Table 3.2 (page 100) of 20%, 32%, and 19% for years
1, 2, and 3, respectively. The resulting book value is $69,600 ($240,000 [(0.20 0.32 0.19) $240,000]). An ordinary gain of $170,400 ($240,000 $69,600) in recaptured depreciation is also realized on the sale. The total taxes
on the gain are $84,160 [($40,000 $170,400) 0.40]. Substituting these
amounts into the format in Table 8.2 results in an initial investment of $221,160,
which represents the net cash outflow required at time zero.
Installed cost of proposed machine
Cost of proposed machine
Installation costs
Total installed cost—proposed
(depreciable value)
After-tax proceeds from sale of present machine
Proceeds from sale of present machine
Tax on sale of present machine
Total after-tax proceeds—present
Change in net working capital
$380,000
2
0
,0
0
0
$400,000
$280,000
84,160
195,840
17,000
1,160
$22
Initial investment
Review Questions
8–9
Explain how each of the following inputs is used to calculate the initial investment: (a) cost of new asset, (b) installation costs, (c) proceeds from sale
of old asset, (d) tax on sale of old asset, and (e) change in net working capital.
8–10 How is the book value of an asset calculated? What are the three key
forms of taxable income?
8–11 What four tax situations may result from the sale of an asset that is being
replaced?
8–12 Referring to the basic format for calculating initial investment, explain
how a firm would determine the depreciable value of the new asset.
CHAPTER 8
LG5
Capital Budgeting Cash Flows
371
8.4 Finding the Operating Cash Inflows
The benefits expected from a capital expenditure or “project” are embodied in its
operating cash inflows, which are incremental after-tax cash inflows. In this section we use the income statement format to develop clear definitions of the terms
after-tax, cash inflows, and incremental.
Interpreting the Term After-Tax
Benefits expected to result from proposed capital expenditures must be measured
on an after-tax basis, because the firm will not have the use of any benefits until it
has satisfied the government’s tax claims. These claims depend on the firm’s taxable income, so deducting taxes before making comparisons between proposed
investments is necessary for consistency when evaluating capital expenditure
alternatives.
Interpreting the Term Cash Inflows
All benefits expected from a proposed project must be measured on a cash flow
basis. Cash inflows represent dollars that can be spent, not merely “accounting
profits.” A simple accounting technique for converting after-tax net profits into
operating cash inflows was given in Equation 3.1 on page 102. The basic calculation requires adding depreciation and any other noncash charges (amortization
and depletion) deducted as expenses on the firm’s income statement back to net
profits after taxes. Because depreciation is commonly found on income statements, it is the only noncash charge we consider.
EXAMPLE
Powell Corporation’s estimates of its revenue and expenses (excluding depreciation), with and without the proposed new machine described in the preceding
example, are given in Table 8.5. Note that both the expected usable life of the
proposed machine and the remaining usable life of the present machine are 5
years. The amount to be depreciated with the proposed machine is calculated by
TABLE 8.5
Powell Corporation’s Revenue and Expenses
(Excluding Depreciation) for Proposed and
Present Machines
With proposed machine
Year
Revenue
(1)
Expenses
(excl. depr.)
(2)
1
$2,520,000
2
2,520,000
3
With present machine
Year
Revenue
(1)
Expenses
(excl. depr.)
(2)
$2,300,000
1
$2,200,000
$1,990,000
2,300,000
2
2,300,000
2,110,000
2,520,000
2,300,000
3
2,400,000
2,230,000
4
2,520,000
2,300,000
4
2,400,000
2,250,000
5
2,520,000
2,300,000
5
2,250,000
2,120,000
372
PART 3
Long-Term Investment Decisions
TABLE 8.6
Year
Depreciation Expense for Proposed and Present
Machines for Powell Corporation
Cost
(1)
Applicable MACRS depreciation
percentages (from Table 3.2)
(2)
Depreciation
[(1) (2)]
(3)
With proposed machine
1
$400,000
2
400,000
20%
32
128,000
3
400,000
19
76,000
4
400,000
12
48,000
5
400,000
12
6
400,000
5
1
0
0
%
20,000
$4
0
0
,0
0
0
12% (year-4 depreciation)
$28,800
Totals
$ 80,000
48,000
With present machine
1
$240,000
2
240,000
12
(year-5 depreciation)
28,800
3
240,000
5
(year-6 depreciation)
12,000
4
5
6
Total
Because the present machine is at the end of the third year of its cost recovery at
the time the analysis is performed, it has only the final 3 years of depreciation
(as noted above) still applicable.
0
0
0
a
$
6
9
,
6
0
0
aThe
total $69,600 represents the book value of the present machine at the end of the third year, as calculated in the preceding example.
summing the purchase price of $380,000 and the installation costs of $20,000.
The proposed machine is to be depreciated under MACRS using a 5-year recovery period.10 The resulting depreciation on this machine for each of the 6 years,
as well as the remaining 3 years of depreciation (years 4, 5, and 6) on the present
machine, are calculated in Table 8.6.11
The operating cash inflows in each year can be calculated by using the
income statement format shown in Table 8.7. Substituting the data from Tables
8.5 and 8.6 into this format and assuming a 40% tax rate, we get Table 8.8. It
demonstrates the calculation of operating cash inflows for each year for both the
proposed and the present machine. Because the proposed machine is depreciated
over 6 years, the analysis must be performed over the 6-year period to capture
fully the tax effect of its year-6 depreciation. The resulting operating cash inflows
are shown in the final row of Table 8.8 for each machine. The $8,000 year-6 cash
inflow for the proposed machine results solely from the tax benefit of its year-6
depreciation deduction.
10. As noted in Chapter 3, it takes n 1 years to depreciate an n-year class asset under current tax law. Therefore,
MACRS percentages are given for each of 6 years for use in depreciating an asset with a 5-year recovery period.
11. It is important to recognize that although both machines will provide 5 years of use, the proposed new machine
will be depreciated over the 6-year period, whereas the present machine, as noted in the preceding example, has been
depreciated over 3 years and therefore has remaining only its final 3 years (years 4, 5, and 6) of depreciation (12%,
12%, and 5%, respectively, under MACRS).
CHAPTER 8
TABLE 8.7
Capital Budgeting Cash Flows
373
Calculation of Operating
Cash Inflows Using the
Income Statement Format
Revenue
Expenses (excluding depreciation)
Profits before depreciation and taxes
Depreciation
Net profits before taxes
Taxes
Net profits after taxes
Depreciation
Operating cash inflows
TABLE 8.8
Calculation of Operating Cash Inflows for Powell Corporation’s
Proposed and Present Machines
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
$2,520,000
$2,520,000
$2,520,000
$2,520,000
$2,520,000
$
2
,3
0
0
,0
0
0
$ 220,000
2
,3
0
0
,0
0
0
$ 220,000
2
,3
0
0
,0
0
0
$ 220,000
2
,3
0
0
,0
0
0
$ 220,000
2
,3
0
0
,0
0
0
$ 220,000
0
$
0
8
0
,0
0
0
$ 140,000
1
2
8
,0
0
0
$ 92,000
7
6
,0
0
0
$ 144,000
4
8
,0
0
0
$ 172,000
4
8
,0
0
0
$ 172,000
2
0
,0
0
0
$20,000
5
6
,0
0
0
$ 84,000
3
6
,8
0
0
$ 55,200
5
7
,6
0
0
$ 86,400
6
8
,8
0
0
$ 103,200
6
8
,8
0
0
$ 103,200
8
,0
0
0
$12,000
8
0
,0
0
0
$
1
6
4
,
0
0
0
1
2
8
,0
0
0
$
1
8
3
,
2
0
0
7
6
,0
0
0
$
1
6
2
,
4
0
0
4
8
,0
0
0
$
1
5
1
,
2
0
0
4
8
,0
0
0
$
1
5
1
,
2
0
0
2
0
,0
0
0
$
8
,
0
0
0
$2,200,000
$2,300,000
$2,400,000
$2,400,000
$2,250,000
$
1,990,000
$ 210,000
2,110,000
$ 190,000
2,230,000
$ 170,000
2,250,000
$ 150,000
2,120,000
$ 130,000
0
$
0
28,800
$ 181,200
28,800
$ 161,200
12,000
$ 158,000
0
$ 150,000
0
$ 130,000
0
$
0
72,480
$ 108,720
64,480
$ 96,720
63,200
$ 94,800
60,000
$ 90,000
52,000
$ 78,000
0
$
0
28,800
$
1
37
,52
0
28,800
$
1
25
,52
0
12,000
$
1
06
,80
0
0
$
9
0
,
0
0
0
0
$
7
8
,
0
0
0
0
$
0
With proposed machine
Revenuea
Expenses (excl. depr.)b
Profits before depr. and taxes
Depreciationc
Net profits before taxes
Taxes (rate 40%)
Net profits after taxes
Depreciationc
Operating cash inflows
0
With present machine
Revenuea
Expenses (excl.
depr.)b
Profits before depr. and taxes
Depreciationc
Net profits before taxes
Taxes (rate 40%)
Net profits after taxes
Depreciationc
Operating cash inflows
aFrom
column 1 of Table 8.5.
column 2 of Table 8.5.
cFrom column 3 of Table 8.6.
bFrom
0
374
PART 3
Long-Term Investment Decisions
Interpreting the Term Incremental
The final step in estimating the operating cash inflows for a proposed project is
to calculate the incremental (relevant) cash inflows. Incremental operating cash
inflows are needed, because our concern is only with the change in operating
cash inflows that result from the proposed project.
EXAMPLE
Table 8.9 demonstrates the calculation of Powell Corporation’s incremental (relevant) operating cash inflows for each year. The estimates of operating cash
inflows developed in Table 8.8 are given in columns 1 and 2. Column 2 values
represent the amount of operating cash inflows that Powell Corporation will
receive if it does not replace the present machine. If the proposed machine replaces
the present machine, the firm’s operating cash inflows for each year will be those
shown in column 1. Subtracting the present machine’s operating cash inflows
from the proposed machine’s operating cash inflows, we get the incremental operating cash inflows for each year, shown in column 3. These cash flows represent
the amounts by which each respective year’s cash inflows will increase as a result
of the replacement. For example, in year 1, Powell Corporation’s cash inflows
would increase by $26,480 if the proposed project were undertaken. Clearly,
these are the relevant inflows to be considered when evaluating the benefits of
making a capital expenditure for the proposed machine.12
TABLE 8.9
Incremental (Relevant) Operating Cash
Inflows for Powell Corporation
Operating cash inflows
Year
Proposed machinea
(1)
Present machinea
(2)
Incremental (relevant)
[(1) (2)]
(3)
1
$164,000
$137,520
$26,480
2
183,200
125,520
57,680
3
162,400
106,800
55,600
4
151,200
90,000
61,200
5
151,200
78,000
73,200
6
8,000
0
8,000
aFrom
final row for respective machine in Table 8.8.
12. The following equation can be used to calculate more directly the incremental cash inflow in year t, ICIt.
ICIt [PBDTt (1 T)] (Dt T)
where
PBDTt change in profits before depreciation and taxes [revenues expenses
(excl. depr.)] in year t
Dt change in depreciation expense in year t
T firm’s marginal tax rate
Applying this formula to the Powell Corporation data given in Tables 8.5 and 8.6 for year 3, we get the following
values of variables:
PBDT3 ($2,520,000 $2,300,000) ($2,400,000 $2,230,000)
$220,000 $170,000 $50,000
CHAPTER 8
Capital Budgeting Cash Flows
375
Review Questions
8–13 How does depreciation enter into the calculation of operating cash
inflows?
8–14 How are the incremental (relevant) operating cash inflows that are associated with a replacement decision calculated?
LG6
8.5 Finding the Terminal Cash Flow
Terminal cash flow is the cash flow resulting from termination and liquidation of
a project at the end of its economic life. It represents the after-tax cash flow,
exclusive of operating cash inflows, that occurs in the final year of the project.
When it applies, this flow can significantly affect the capital expenditure decision.
Terminal cash flow can be calculated for replacement projects by using the basic
format presented in Table 8.10.
Proceeds from Sale of Assets
The proceeds from sale of the new and the old asset, often called “salvage value,”
represent the amount net of any removal or cleanup costs expected upon termination of the project. For replacement projects, proceeds from both the new asset
and the old asset must be considered. For expansion and renewal types of capital
expenditures, the proceeds from the old asset are zero. Of course, it is not
unusual for the value of an asset to be zero at the termination of a project.
TABLE 8.10
The Basic Format
for Determining
Terminal Cash Flow
After-tax proceeds from sale of new asset Proceeds from sale of new asset
Tax on sale of new asset
After-tax proceeds from sale of old asset Proceeds from sale of old asset
Tax on sale of old asset
Change in net working capital
Terminal cash flow
D3 $76,000 $12,000 $64,000
T 0.40
Substituting into the equation yields
ICI3 [$50,000 (1 0.40)] ($64,000 0.40)
$30,000 $25,600 $55,600
The $55,600 of incremental cash inflow for year 3 is the same value as that calculated for year 3 in column 3 of
Table 8.9.
376
PART 3
Long-Term Investment Decisions
Taxes on Sale of Assets
Earlier we calculated the tax on sale of old asset (as part of finding the initial
investment). Similarly, taxes must be considered on the terminal sale of both the
new and the old asset for replacement projects and on only the new asset in other
cases. The tax calculations apply whenever an asset is sold for a value different
from its book value. If the net proceeds from the sale are expected to exceed book
value, a tax payment shown as an outflow (deduction from sale proceeds) will
occur. When the net proceeds from the sale are less than book value, a tax rebate
shown as a cash inflow (addition to sale proceeds) will result. For assets sold to
net exactly book value, no taxes will be due.
Change in Net Working Capital
When we calculated the initial investment, we took into account any change in net
working capital that is attributable to the new asset. Now, when we calculate the
terminal cash flow, the change in net working capital represents the reversion of
any initial net working capital investment. Most often, this will show up as a cash
inflow due to the reduction in net working capital; with termination of the project,
the need for the increased net working capital investment is assumed to end.13
Because the net working capital investment is in no way consumed, the amount
recovered at termination will equal the amount shown in the calculation of the initial investment.14 Tax considerations are not involved.
Calculating the terminal cash flow involves the same procedures as those
used to find the initial investment. In the following example, the terminal cash
flow is calculated for a replacement decision.
EXAMPLE
Continuing with the Powell Corporation example, assume that the firm expects
to be able to liquidate the new machine at the end of its 5-year usable life to net
$50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $0 because it will then be completely obsolete. The firm expects to recover its $17,000 net working capital investment upon
termination of the project. Both ordinary income and capital gains are taxed at a
rate of 40%.
From the analysis of the operating cash inflows presented earlier, we can see
that the proposed (new) machine will have a book value of $20,000 (equal to the
year-6 depreciation) at the end of 5 years. The present (old) machine will be fully
depreciated and therefore have a book value of zero at the end of the 5 years.
Because the sale price of $50,000 for the proposed (new) machine is below its initial installed cost of $400,000 but greater than its book value of $20,000, taxes
will have to be paid only on the recaptured depreciation of $30,000 ($50,000 sale
proceeds $20,000 book value). Applying the ordinary tax rate of 40% to this
$30,000 results in a tax of $12,000 (0.40 $30,000) on the sale of the proposed
machine. Its after-tax sale proceeds would therefore equal $38,000 ($50,000 sale
13. As noted earlier, the change in net working capital is for convenience assumed to occur instantaneously—in this
case, on termination of the project. In actuality, it may take a number of months for the original increase in net
working capital to be worked down to zero.
14. In practice, the full net working capital investment may not be recovered. This occurs because some accounts
receivable may not be collectible and some inventory will probably be obsolete, and so their book values cannot be
fully realized.
CHAPTER 8
Capital Budgeting Cash Flows
377
proceeds $12,000 taxes). Because the present machine would net $0 at termination and its book value would be $0, no tax would be due on its sale. Its aftertax sale proceeds would therefore equal $0. Substituting the appropriate values
into the format in Table 8.10 results in the terminal cash inflow of $55,000.
After-tax proceeds from sale of proposed machine
Proceeds from sale of proposed machine
Tax on sale of proposed machine
Total after-tax proceeds—proposed
After-tax proceeds from sale of present machine
Proceeds from sale of present machine
Tax on sale of present machine
Total after-tax proceeds—present
Change in net working capital
$50,000
12,000
0
0
$38,000
$
Terminal cash flow
0
17,000
$55
,00
0
Review Question
8–15 Explain how the terminal cash flow is calculated for replacement projects.
LG4
LG5
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8.6 Summarizing the Relevant Cash Flows
Hint Capital expenditures are critical to a firm’s
success, and these funds are
usually limited. Because of
this, the process of determining cash flows should be
finely tuned so that it is both
objective and realistic.
EXAMPLE
The initial investment, operating cash inflows, and terminal cash flow together
represent a project’s relevant cash flows. These cash flows can be viewed as the
incremental after-tax cash flows attributable to the proposed project. They represent, in a cash flow sense, how much better or worse off the firm will be if it
chooses to implement the proposal.
The relevant cash flows for Powell Corporation’s proposed replacement expenditure can now be shown graphically, on a time line. Note that because the new
asset is assumed to be sold at the end of its 5-year usable life, the year-6 incremental operating cash inflow calculated in Table 8.9 has no relevance; the terminal cash flow effectively replaces this value in the analysis. As the following time
line shows, the relevant cash flows follow a conventional cash flow pattern.
Time line for Powell
Corporation’s relevant
cash flows with the
proposed machine
$26,480
$57,680
$55,600
$61,200
1
2
3
4
$ 55,000 Terminal Cash Flow
73,200 Operating Cash Inflow
$128,200 Total Cash Flow
0
$221,160
End of Year
5
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Long-Term Investment Decisions
Techniques for analyzing conventional cash flow patterns to determine
whether to undertake a proposed capital investment are discussed in Chapter 9.
Review Question
8–16 Diagram and describe the three components of the relevant cash flows for
a capital budgeting project.
S U M M A RY
FOCUS ON VALUE
A key responsibility of financial managers is to review and analyze proposed investment
decisions in order to make sure that only those that contribute positively to the value of the
firm are undertaken. Utilizing a variety of tools and techniques, financial managers estimate
the cash flows that a proposed investment will generate and then apply appropriate decision
techniques to assess the investment’s impact on the firm’s value. The most difficult and
important aspect of this capital budgeting process is developing good estimates of the relevant cash flows.
The relevant cash flows are the incremental after-tax cash flows resulting from a proposed investment. These estimates represent the cash flow benefits that are likely to accrue
to the firm as a result of implementing the investment. By applying to the cash flows decision techniques that capture time value of money and risk factors, the financial manager
can estimate the impact the investment will have on the firm’s share price. Clearly, only
those investments that can be expected to increase the stock price should be undertaken.
Consistent application of capital budgeting procedures to proposed long-term investments
should therefore allow the firm to maximize its stock price.
REVIEW OF LEARNING GOALS
Understand the key motives for capital expenditure and the steps in the capital budgeting
process. Capital budgeting is the process used to
evaluate and select capital expenditures consistent
with the firm’s goal of maximizing owner wealth.
Capital expenditures are long-term investments
made to expand, replace, or renew fixed assets or to
obtain some less tangible benefit. The capital budgeting process includes five distinct but interrelated
LG1
steps: proposal generation, review and analysis,
decision making, implementation, and follow-up.
Define basic capital budgeting terminology.
Capital expenditure proposals may be independent or mutually exclusive. Typically, firms have
only limited funds for capital investments and must
ration them among carefully selected projects. Two
basic approaches to capital budgeting decisions are
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CHAPTER 8
the accept–reject approach and the ranking approach. Conventional cash flow patterns consist of
an initial outflow followed by a series of inflows;
any other pattern is nonconventional.
Discuss the major components of relevant cash
flows, expansion versus replacement cash
flows, sunk costs and opportunity costs, and international capital budgeting and long-term investments. The relevant cash flows for capital budgeting
decisions are the initial investment, the operating
cash inflows, and the terminal cash flow. For replacement decisions, these flows are found by determining the difference between the cash flows of the
new asset and the old asset. Expansion decisions are
viewed as replacement decisions in which all cash
flows from the old asset are zero. When estimating
relevant cash flows, one should ignore sunk costs,
and opportunity costs should be included as cash
outflows. In international capital budgeting, currency risks and political risks can be minimized
through careful planning.
LG3
Calculate the initial investment associated with
LG4
a proposed capital expenditure. The initial
investment is the initial outflow required, taking
into account the installed cost of the new asset, the
after-tax proceeds from the sale of the old asset, and
any change in net working capital. Finding the
after-tax proceeds from sale of the old asset, which
reduces the initial investment, involves cost, depreciation, and tax data. The book value of an asset is
its accounting value, which is used to determine
what taxes are owed as a result of its sale. Any of
three forms of taxable income—capital gain, recap-
SELF-TEST PROBLEMS
LG4
ST 8–1
Capital Budgeting Cash Flows
379
tured depreciation, or a loss—can result from sale
of an asset. The form of taxable income that applies
depends on whether the asset is sold for (1) more
than its initial purchase price, (2) more than book
value but less than what was initially paid, (3) book
value, or (4) less than book value. The change in net
working capital is the difference between the change
in current assets and the change in current liabilities
expected to accompany a given capital expenditure.
Determine relevant operating cash inflows using the income statement format. The operating
cash inflows are the incremental after-tax cash inflows expected to result from a project. The income
statement format involves adding depreciation back
to net profits after taxes and gives the operating
cash inflows associated with the proposed and present projects. The relevant (incremental) cash inflows
are the difference between the operating cash inflows of the proposed project and those of the present project.
LG5
Find the terminal cash flow. The terminal cash
flow represents the after-tax cash flow, exclusive of operating cash inflows, that is expected
from liquidation of a project. It is calculated by
finding the difference between the after-tax proceeds from sale of the new and the old asset at
project termination and then adjusting this difference for any change in net working capital. Sale
price and depreciation data are used to find the
taxes and the after-tax sale proceeds on the new
and old assets. The change in net working capital
typically represents the reversion of any initial net
working capital investment.
LG6
(Solutions in Appendix B)
Book value, taxes, and initial investment Irvin Enterprises is considering the
purchase of a new piece of equipment to replace the current equipment. The new
equipment costs $75,000 and requires $5,000 in installation costs. It will be
depreciated under MACRS using a 5-year recovery period. The old piece of
equipment was purchased 4 years ago for an installed cost of $50,000; it was
being depreciated under MACRS using a 5-year recovery period. The old equipment can be sold today for $55,000 net of any removal or cleanup costs. As a
result of the proposed replacement, the firm’s investment in net working capital
is expected to increase by $15,000. The firm pays taxes at a rate of 40% on both
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PART 3
Long-Term Investment Decisions
ordinary income and capital gains. (Table 3.2 on page 100 contains the applicable MACRS depreciation percentages.)
a. Calculate the book value of the old piece of equipment.
b. Determine the taxes, if any, attributable to the sale of the old equipment.
c. Find the initial investment associated with the proposed equipment
replacement.
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LG5
LG6
ST 8–2
Determining relevant cash flows A machine currently in use was originally purchased 2 years ago for $40,000. The machine is being depreciated under
MACRS using a 5-year recovery period; it has 3 years of usable life remaining.
The current machine can be sold today to net $42,000 after removal and
cleanup costs. A new machine, using a 3-year MACRS recovery period, can be
purchased at a price of $140,000. It requires $10,000 to install and has a 3-year
usable life. If the new machine is acquired, the investment in accounts receivable
will be expected to rise by $10,000, the inventory investment will increase by
$25,000, and accounts payable will increase by $15,000. Profits before depreciation and taxes are expected to be $70,000 for each of the next 3 years with the
old machine and to be $120,000 in the first year and $130,000 in the second
and third years with the new machine. At the end of 3 years, the market value of
the old machine will equal zero, but the new machine could be sold to net
$35,000 before taxes. Both ordinary corporate income and capital gains are subject to a 40% tax. (Table 3.2 on page 100 contains the applicable MACRS
depreciation percentages.)
a. Determine the initial investment associated with the proposed replacement
decision.
b. Calculate the incremental operating cash inflows for years 1 to 4 associated
with the proposed replacement. (Note: Only depreciation cash flows must be
considered in year 4.)
c. Calculate the terminal cash flow associated with the proposed replacement
decision. (Note: This is at the end of year 3.)
d. Depict on a time line the relevant cash flows found in parts a, b, and c that
are associated with the proposed replacement decision, assuming that it is terminated at the end of year 3.
PROBLEMS
LG1
8–1
Classification of expenditures Given the following list of outlays, indicate
whether each is normally considered a capital or an operating expenditure.
Explain your answers.
a. An initial lease payment of $5,000 for electronic point-of-sale cash register
systems.
b. An outlay of $20,000 to purchase patent rights from an inventor.
c. An outlay of $80,000 for a major research and development program.
d. An $80,000 investment in a portfolio of marketable securities.
e. A $300 outlay for an office machine.
f. An outlay of $2,000 for a new machine tool.
g. An outlay of $240,000 for a new building.
h. An outlay of $1,000 for a marketing research report.
CHAPTER 8
LG2
8–2
Capital Budgeting Cash Flows
381
Basic terminology A firm is considering the following three separate situations.
Situation A Build either a small office building or a convenience store on a parcel of land located in a high-traffic area. Adequate funding is available, and both
projects are known to be acceptable. The office building requires an initial
investment of $620,000 and is expected to provide operating cash inflows of
$40,000 per year for 20 years. The convenience store is expected to cost
$500,000 and to provide a growing stream of operating cash inflows over its 20year life. The initial operating cash inflow is $20,000, and it will increase by 5%
each year.
Situation B Replace a machine with a new one that requires a $60,000 initial
investment and will provide operating cash inflows of $10,000 per year for the
first 5 years. At the end of year 5, a machine overhaul costing $20,000 will be
required. After it is completed, expected operating cash inflows will be $10,000
in year 6; $7,000 in year 7; $4,000 in year 8; and $1,000 in year 9, at the end of
which the machine will be scrapped.
Situation C Invest in any or all of the four machines whose relevant cash flows
are given in the following table. The firm has $500,000 budgeted to fund these
machines, all of which are known to be acceptable. Initial investment for each
machine is $250,000.
Operating cash inflows
Year
Machine 1
Machine 2
Machine 3
Machine 4
1
$ 50,000
$70,000
$65,000
$90,000
2
70,000
70,000
65,000
80,000
3
90,000
70,000
80,000
70,000
4
30,000
70,000
80,000
60,000
5
100,000
70,000
20,000
50,000
For each situation, indicate:
a. Whether the projects involved are independent or mutually exclusive.
b. Whether the availability of funds is unlimited or capital rationing exists.
c. Whether accept–reject or ranking decisions are required.
d. Whether each project’s cash flows are conventional or nonconventional.
LG3
8–3
Relevant cash flow pattern fundamentals For each of the following projects,
determine the relevant cash flows, classify the cash flow pattern, and depict the
cash flows on a time line.
a. A project that requires an initial investment of $120,000 and will generate
annual operating cash inflows of $25,000 for the next 18 years. In each of
the 18 years, maintenance of the project will require a $5,000 cash outflow.
b. A new machine with an installed cost of $85,000. Sale of the old machine
will yield $30,000 after taxes. Operating cash inflows generated by the
replacement will exceed the operating cash inflows of the old machine by
$20,000 in each year of a 6-year period. At the end of year 6, liquidation of
the new machine will yield $20,000 after taxes, which is $10,000 greater
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PART 3
Long-Term Investment Decisions
than the after-tax proceeds expected from the old machine had it been
retained and liquidated at the end of year 6.
c. An asset that requires an initial investment of $2 million and will yield
annual operating cash inflows of $300,000 for each of the next 10 years.
Operating cash outlays will be $20,000 for each year except year 6,
when an overhaul requiring an additional cash outlay of $500,000 will be
required. The asset’s liquidation value at the end of year 10 is expected to
be $0.
LG3
8–4
Expansion versus replacement cash flows Edison Systems has estimated the
cash flows over the 5-year lives for two projects, A and B. These cash flows are
summarized in the following table.
Initial investment
Year
Project A
Project B
$40,000
$12,000a
Operating cash inflows
1
$10,000
$ 6,000
2
12,000
6,000
3
14,000
6,000
4
16,000
6,000
5
10,000
6,000
aAfter-tax
cash inflow expected from liquidation.
a. If project A were actually a replacement for project B and if the $12,000 initial investment shown for project B were the after-tax cash inflow expected
from liquidating it, what would be the relevant cash flows for this replacement decision?
b. How can an expansion decision such as project A be viewed as a special form
of a replacement decision? Explain.
LG3
8–5
Sunk costs and opportunity costs Masters Golf Products, Inc., spent 3 years
and $1,000,000 to develop its new line of club heads to replace a line that is
becoming obsolete. In order to begin manufacturing them, the company will
have to invest $1,800,000 in new equipment. The new clubs are expected to generate an increase in operating cash inflows of $750,000 per year for the next 10
years. The company has determined that the existing line could be sold to a competitor for $250,000.
a. How should the $1,000,000 in development costs be classified?
b. How should the $250,000 sale price for the existing line be classified?
c. Depict all of the known relevant cash flows on a time line.
LG3
8–6
Sunk costs and opportunity costs Covol Industries is developing the relevant
cash flows associated with the proposed replacement of an existing machine tool
with a new, technologically advanced one. Given the following costs related to
the proposed project, explain whether each would be treated as a sunk cost or
an opportunity cost in developing the relevant cash flows associated with the
proposed replacement decision.
CHAPTER 8
Capital Budgeting Cash Flows
383
a. Covol would be able to use the same tooling, which had a book value of
$40,000, on the new machine tool as it had used on the old one.
b. Covol would be able to use its existing computer system to develop programs
for operating the new machine tool. The old machine tool did not require
these programs. Although the firm’s computer has excess capacity available,
the capacity could be leased to another firm for an annual fee of $17,000.
c. Covol would have to obtain additional floor space to accommodate the
larger new machine tool. The space that would be used is currently being
leased to another company for $10,000 per year.
d. Covol would use a small storage facility to store the increased output of the
new machine tool. The storage facility was built by Covol 3 years earlier at a
cost of $120,000. Because of its unique configuration and location, it is currently of no use to either Covol or any other firm.
e. Covol would retain an existing overhead crane, which it had planned to sell
for its $180,000 market value. Although the crane was not needed with the
old machine tool, it would be used to position raw materials on the new
machine tool.
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8–7
Book value Find the book value for each of the assets shown in the following
table, assuming that MACRS depreciation is being used. (Note: See Table 3.2 on
page 100 for the applicable depreciation percentages.)
Asset
Installed cost
Recovery
period
(years)
Elapsed time
since purchase
(years)
A
$ 950,000
5
3
B
40,000
3
1
C
96,000
5
4
D
350,000
5
1
E
1,500,000
7
5
LG4
8–8
Book value and taxes on sale of assets Troy Industries purchased a new
machine 3 years ago for $80,000. It is being depreciated under MACRS with a
5-year recovery period using the percentages given in Table 3.2 on page 100.
Assume 40% ordinary and capital gains tax rates.
a. What is the book value of the machine?
b. Calculate the firm’s tax liability if it sold the machine for each of the following amounts: $100,000; $56,000; $23,200; and $15,000.
LG4
8–9
Tax calculations For each of the following cases, describe the various taxable
components of the funds received through sale of the asset, and determine the
total taxes resulting from the transaction. Assume 40% ordinary and capital
gains tax rates. The asset was purchased 2 years ago for $200,000 and is being
depreciated under MACRS using a 5-year recovery period. (See Table 3.2 on
page 100 for the applicable depreciation percentages.)
a. The asset is sold for $220,000.
b. The asset is sold for $150,000.
c. The asset is sold for $96,000.
d. The asset is sold for $80,000.
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Long-Term Investment Decisions
8–10
Change in net working capital calculation Samuels Manufacturing is considering the purchase of a new machine to replace one they feel is obsolete. The firm
has total current assets of $920,000 and total current liabilities of $640,000. As
a result of the proposed replacement, the following changes are anticipated in
the levels of the current asset and current liability accounts noted.
Account
Change
Accruals
$ 40,000
Marketable securities
0
Inventories
10,000
Accounts payable
90,000
Notes payable
0
Accounts receivable
150,000
Cash
15,000
a. Using the information given, calculate the change, if any, in net working capital that is expected to result from the proposed replacement action.
b. Explain why a change in these current accounts would be relevant in determining the initial investment for the proposed capital expenditure.
c. Would the change in net working capital enter into any of the other cash
flow components that make up the relevant cash flows? Explain.
LG4
8–11
Calculating initial investment Vastine Medical, Inc., is considering replacing its
existing computer system, which was purchased 2 years ago at a cost of
$325,000. The system can be sold today for $200,000. It is being depreciated
using MACRS and a 5-year recovery period (see Table 3.2, page 100). A new
computer system will cost $500,000 to purchase and install. Replacement of the
computer system would not involve any change in net working capital. Assume a
40% tax rate on ordinary income and capital gains.
a. Calculate the book value of the existing computer system.
b. Calculate the after-tax proceeds of its sale for $200,000.
c. Calculate the initial investment associated with the replacement project.
LG4
8–12
Initial investment—Basic calculation Cushing Corporation is considering the
purchase of a new grading machine to replace the existing one. The existing
machine was purchased 3 years ago at an installed cost of $20,000; it was being
depreciated under MACRS using a 5-year recovery period. (See Table 3.2 on
page 100 for the applicable depreciation percentages.) The existing machine is
expected to have a usable life of at least 5 more years. The new machine costs
$35,000 and requires $5,000 in installation costs; it will be depreciated using a
5-year recovery period under MACRS. The existing machine can currently be
sold for $25,000 without incurring any removal or cleanup costs. The firm pays
40% taxes on both ordinary income and capital gains. Calculate the initial
investment associated with the proposed purchase of a new grading machine.
LG4
8–13
Initial investment at various sale prices Edwards Manufacturing Company is
considering replacing one machine with another. The old machine was pur-
CHAPTER 8
Capital Budgeting Cash Flows
385
chased 3 years ago for an installed cost of $10,000. The firm is depreciating the
machine under MACRS, using a 5-year recovery period. (See Table 3.2 on page
100 for the applicable depreciation percentages.) The new machine costs
$24,000 and requires $2,000 in installation costs. The firm is subject to a 40%
tax rate on both ordinary income and capital gains. In each of the following
cases, calculate the initial investment for the replacement.
a. Edwards Manufacturing Company (EMC) sells the old machine for
$11,000.
b. EMC sells the old machine for $7,000.
c. EMC sells the old machine for $2,900.
d. EMC sells the old machine for $1,500.
LG4
8–14
Calculating initial investment DuPree Coffee Roasters, Inc., wishes to expand
and modernize its facilities. The installed cost of a proposed computer-controlled
automatic-feed roaster will be $130,000. The firm has a chance to sell its 4-yearold roaster for $35,000. The existing roaster originally cost $60,000 and was
being depreciated using MACRS and a 7-year recovery period (see Table 3.2
on page 100). DuPree pays taxes at a rate of 40% on ordinary income and capital gains.
a. What is the book value of the existing roaster?
b. Calculate the after-tax proceeds of the sale of the existing roaster.
c. Calculate the change in net working capital using the following figures:
Anticipated Changes
in Current Assets
and Current Liabilities
Accruals
$20,000
Inventory
50,000
Accounts payable
40,000
Accounts receivable
70,000
Cash
Notes payable
0
15,000
d. Calculate the initial investment associated with the proposed new roaster.
LG5
8–15
Depreciation A firm is evaluating the acquisition of an asset that costs
$64,000 and requires $4,000 in installation costs. If the firm depreciates the
asset under MACRS, using a 5-year recovery period (see Table 3.2 on page 100
for the applicable depreciation percentages), determine the depreciation charge
for each year.
LG5
8–16
Incremental operating cash inflows A firm is considering renewing its equipment to meet increased demand for its product. The cost of equipment modifications is $1.9 million plus $100,000 in installation costs. The firm will depreciate
the equipment modifications under MACRS, using a 5-year recovery period. (See
Table 3.2 on page 100 for the applicable depreciation percentages.) Additional
sales revenue from the renewal should amount to $1.2 million per year, and
additional operating expenses and other costs (excluding depreciation) will
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PART 3
Long-Term Investment Decisions
amount to 40% of the additional sales. The firm has an ordinary tax rate of
40%. (Note: Answer the following questions for each of the next 6 years.)
a. What incremental earnings before depreciation and taxes will result from the
renewal?
b. What incremental earnings after taxes will result from the renewal?
c. What incremental operating cash inflows will result from the renewal?
LG5
8–17
Incremental operating cash inflows—Expense reduction Miller Corporation is
considering replacing a machine. The replacement will reduce operating
expenses (that is, increase revenues) by $16,000 per year for each of the 5 years
the new machine is expected to last. Although the old machine has zero book
value, it can be used for 5 more years. The depreciable value of the new machine
is $48,000. The firm will depreciate the machine under MACRS using a 5-year
recovery period (see Table 3.2 on page 100 for the applicable depreciation percentages) and is subject to a 40% tax rate on ordinary income. Estimate the
incremental operating cash inflows generated by the replacement. (Note: Be sure
to consider the depreciation in year 6.)
LG5
8–18
Incremental operating cash inflows Strong Tool Company has been considering purchasing a new lathe to replace a fully depreciated lathe that will last 5
more years. The new lathe is expected to have a 5-year life and depreciation
charges of $2,000 in year 1; $3,200 in year 2; $1,900 in year 3; $1,200 in both
year 4 and year 5; and $500 in year 6. The firm estimates the revenues and
expenses (excluding depreciation) for the new and the old lathes to be as shown
in the following table. The firm is subject to a 40% tax rate on ordinary income.
New lathe
Expenses
(excl. depr.)
Old lathe
Revenue
Expenses
(excl. depr.)
Year
Revenue
1
$40,000
$30,000
$35,000
$25,000
2
41,000
30,000
35,000
25,000
3
42,000
30,000
35,000
25,000
4
43,000
30,000
35,000
25,000
5
44,000
30,000
35,000
25,000
a. Calculate the operating cash inflows associated with each lathe. (Note: Be
sure to consider the depreciation in year 6.)
b. Calculate the incremental (relevant) operating cash inflows resulting from the
proposed lathe replacement.
c. Depict on a time line the incremental operating cash inflows calculated in
part b.
LG5
8–19
Determining operating cash inflows Scenic Tours, Inc., is a provider of bus
tours throughout the New England area. The corporation is considering the
replacement of 10 of its older buses. The existing buses were purchased 4 years
ago at a total cost of $2,700,000 and are being depreciated using MACRS and a
5-year recovery period (see Table 3.2, page 100). The new buses would have
larger passenger capacity and better fuel efficiency as well as lower maintenance
CHAPTER 8
387
Capital Budgeting Cash Flows
costs. The total cost for 10 new buses is $3,000,000. Like the older buses, the
new ones would be depreciated using MACRS and a 5-year recovery period.
Scenic is taxed at a rate of 40% on ordinary income and capital gains. The following table presents revenues and cash expenses for the proposed purchase as
well as the present fleet. Use all of the information given to calculate operating
cash inflows for the proposed and present buses.
Year
1
2
3
$1,850,000
$1,850,000
$1,830,000
460,000
460,000
468,000
$1,800,000
$1,800,000
500,000
510,000
4
5
6
$1,825,000
$1,815,000
$1,800,000
472,000
485,000
500,000
$1,790,000
$1,785,000
$1,775,000
$1,750,000
520,000
520,000
530,000
535,000
With the proposed new buses
Revenue
Expenses (excl. depreciation)
With the present buses
Revenue
Expenses (excl. depreciation)
LG6
8–20
Terminal cash flow—Various lives and sale prices Looner Industries is currently analyzing the purchase of a new machine that costs $160,000 and requires
$20,000 in installation costs. Purchase of this machine is expected to result in an
increase in net working capital of $30,000 to support the expanded level of
operations. The firm plans to depreciate the machine under MACRS using a
5-year recovery period (see Table 3.2 on page 100 for the applicable depreciation percentages) and expects to sell the machine to net $10,000 before taxes at
the end of its usable life. The firm is subject to a 40% tax rate on both ordinary
and capital gains income.
a. Calculate the terminal cash flow for a usable life of (1) 3 years, (2) 5 years,
and (3) 7 years.
b. Discuss the effect of usable life on terminal cash flows using your findings in
part a.
c. Assuming a 5-year usable life, calculate the terminal cash flow if the machine
were sold to net (1) $9,000 or (2) $170,000 (before taxes) at the end of 5 years.
d. Discuss the effect of sale price on terminal cash flow using your findings in
part c.
LG6
8–21
Terminal cash flow—Replacement decision Russell Industries is considering
replacing a fully depreciated machine that has a remaining useful life of 10 years
with a newer, more sophisticated machine. The new machine will cost $200,000
and will require $30,000 in installation costs. It will be depreciated under
MACRS using a 5-year recovery period (see Table 3.2 on page 100 for the
applicable depreciation percentages). A $25,000 increase in net working capital
will be required to support the new machine. The firm’s managers plans to evaluate the potential replacement over a 4-year period. They estimate that the old
machine could be sold at the end of 4 years to net $15,000 before taxes; the new
machine at the end of 4 years will be worth $75,000 before taxes. Calculate the
terminal cash flow at the end of year 4 that is relevant to the proposed purchase
of the new machine. The firm is subject to a 40% tax rate on both ordinary and
capital gains income.
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LG4
LG5
Long-Term Investment Decisions
LG6
8–22
Relevant cash flows for a marketing campaign Marcus Tube, a manufacturer
of high-quality aluminum tubing, has maintained stable sales and profits over
the past 10 years. Although the market for aluminum tubing has been expanding
by 3% per year, Marcus has been unsuccessful in sharing this growth. To
increase its sales, the firm is considering an aggressive marketing campaign that
centers on regularly running ads in all relevant trade journals and exhibiting
products at all major regional and national trade shows. The campaign is
expected to require an annual tax-deductible expenditure of $150,000 over the
next 5 years. Sales revenue, as shown in the income statement for 2003 (below),
totaled $20,000,000. If the proposed marketing campaign is not initiated, sales
are expected to remain at this level in each of the next 5 years, 2004–2008. With
the marketing campaign, sales are expected to rise to the levels shown in the
accompanying table for each of the next 5 years; cost of goods sold is expected
to remain at 80% of sales; general and administrative expense (exclusive of any
marketing campaign outlays) is expected to remain at 10% of sales; and annual
depreciation expense is expected to remain at $500,000. Assuming a 40% tax
rate, find the relevant cash flows over the next 5 years associated with the proposed marketing campaign.
Marcus Tube
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$20,000,000
Less: Cost of goods sold (80%)
16,000,000
$ 4,000,000
Gross profits
Year
Sales revenue
2004
$20,500,000
General and administrative expense (10%)
$2,000,000
2005
21,000,000
Depreciation expense
5
0
0
,0
0
0
2006
21,500,000
2007
22,500,000
2008
23,500,000
Less: Operating expenses
Total operating expense
Net profits before taxes
Less: Taxes (rate 40%)
Net profits after taxes
LG4
Marcus Tube
Sales Forecast
LG5
8–23
2
,5
0
0
,0
0
0
$ 1,500,000
6
0
0
,0
0
0
$
9
0
0
,
0
0
0
Relevant cash flows—No terminal value Central Laundry and Cleaners is considering replacing an existing piece of machinery with a more sophisticated
machine. The old machine was purchased 3 years ago at a cost of $50,000, and
this amount was being depreciated under MACRS using a 5-year recovery
period. The machine has 5 years of usable life remaining. The new machine that
is being considered costs $76,000 and requires $4,000 in installation costs. The
new machine would be depreciated under MACRS using a 5-year recovery
period. The firm can currently sell the old machine for $55,000 without incurring any removal or cleanup costs. The firm pays a tax rate of 40% on both
ordinary income and capital gains. The revenues and expenses (excluding depreciation) associated with the new and the old machine for the next 5 years are
given in the table below. (Table 3.2 on page 100 contains the applicable
MACRS depreciation percentages.)
CHAPTER 8
New machine
Year
Revenue
Capital Budgeting Cash Flows
389
Old machine
Expenses
(excl. depr.)
Revenue
Expenses
(excl. depr.)
1
$750,000
$720,000
$674,000
$660,000
2
750,000
720,000
676,000
660,000
3
750,000
720,000
680,000
660,000
4
750,000
720,000
678,000
660,000
5
750,000
720,000
674,000
660,000
a. Calculate the initial investment associated with replacement of the old
machine by the new one.
b. Determine the incremental operating cash inflows associated with
the proposed replacement. (Note: Be sure to consider the depreciation in
year 6.)
c. Depict on a time line the relevant cash flows found in parts a and b associated with the proposed replacement decision.
LG4
LG5
LG6
8–24
Integrative—Determining relevant cash flows Lombard Company is contemplating the purchase of a new high-speed widget grinder to replace the existing
grinder. The existing grinder was purchased 2 years ago at an installed cost of
$60,000; it was being depreciated under MACRS using a 5-year recovery
period. The existing grinder is expected to have a usable life of 5 more years.
The new grinder costs $105,000 and requires $5,000 in installation costs; it has
a 5-year usable life and would be depreciated under MACRS using a 5-year
recovery period. Lombard can currently sell the existing grinder for $70,000
without incurring any removal or cleanup costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would
increase by $40,000, inventories by $30,000, and accounts payable by $58,000.
At the end of 5 years, the existing grinder is expected to have a market value of
zero; the new grinder would be sold to net $29,000 after removal and cleanup
costs and before taxes. The firm pays taxes at a rate of 40% on both ordinary
income and capital gains. The estimated profits before depreciation and taxes
over the 5 years for both the new and the existing grinder are shown in the following table. (Table 3.2 on page 100 contains the applicable MACRS depreciation percentages.)
Profits before
depreciation and taxes
Year
New grinder
Existing grinder
1
$43,000
$26,000
2
43,000
24,000
3
43,000
22,000
4
43,000
20,000
5
43,000
18,000
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PART 3
Long-Term Investment Decisions
a. Calculate the initial investment associated with the replacement of the existing grinder by the new one.
b. Determine the incremental operating cash inflows associated with the proposed grinder replacement. (Note: Be sure to consider the depreciation in
year 6.)
c. Determine the terminal cash flow expected at the end of year 5 from the proposed grinder replacement.
d. Depict on a time line the relevant cash flows associated with the proposed
grinder replacement decision.
LG4
LG5
LG6
8–25
Integrative—Determining relevant cash flows Atlantic Drydock is considering
replacing an existing hoist with one of two newer, more efficient pieces of equipment. The existing hoist is 3 years old, cost $32,000, and is being depreciated
under MACRS using a 5-year recovery period. Although the existing hoist has
only 3 years (years 4, 5, and 6) of depreciation remaining under MACRS, it has
a remaining usable life of 5 years. Hoist A, one of the two possible replacement
hoists, costs $40,000 to purchase and $8,000 to install. It has a 5-year usable life
and will be depreciated under MACRS using a 5-year recovery period. The other
hoist, B, costs $54,000 to purchase and $6,000 to install. It also has a 5-year
usable life and will be depreciated under MACRS using a 5-year recovery period.
Increased investments in net working capital will accompany the decision to
acquire hoist A or hoist B. Purchase of hoist A would result in a $4,000 increase
in net working capital; hoist B would result in a $6,000 increase in net working
capital. The projected profits before depreciation and taxes with each alternative
hoist and the existing hoist are given in the following table.
Profits before
depreciation and taxes
Year
With hoist A
With hoist B
With existing hoist
1
$21,000
$22,000
$14,000
2
21,000
24,000
14,000
3
21,000
26,000
14,000
4
21,000
26,000
14,000
5
21,000
26,000
14,000
The existing hoist can currently be sold for $18,000 and will not incur any
removal or cleanup costs. At the end of 5 years, the existing hoist can be sold to
net $1,000 before taxes. Hoists A and B can be sold to net $12,000 and $20,000
before taxes, respectively, at the end of the 5-year period. The firm is subject to a
40% tax rate on both ordinary income and capital gains. (Table 3.2 on page 100
contains the applicable MACRS depreciation percentages.)
a. Calculate the initial investment associated with each alternative.
b. Calculate the incremental operating cash inflows associated with each alternative. (Note: Be sure to consider the depreciation in year 6.)
c. Calculate the terminal cash flow at the end of year 5 associated with each
alternative.
d. Depict on a time line the relevant cash flows associated with each alternative.
CHAPTER 8
CHAPTER 8 CASE
Capital Budgeting Cash Flows
391
Developing Relevant Cash Flows for Clark Upholstery
Company’s Machine Renewal or Replacement Decision
B
o Humphries, chief financial officer of Clark Upholstery Company, expects
the firm’s net profits after taxes for the next 5 years to be as shown in the
following table.
Year
Net profits after taxes
1
$100,000
2
150,000
3
200,000
4
250,000
5
320,000
Bo is beginning to develop the relevant cash flows needed to analyze
whether to renew or replace Clark’s only depreciable asset, a machine that originally cost $30,000, has a current book value of zero, and can now be sold for
$20,000. (Note: Because the firm’s only depreciable asset is fully depreciated—
its book value is zero—its expected net profits after taxes equal its operating
cash inflows.) He estimates that at the end of 5 years, the existing machine can
be sold to net $2,000 before taxes. Bo plans to use the following information to
develop the relevant cash flows for each of the alternatives.
Alternative 1 Renew the existing machine at a total depreciable cost of $90,000.
The renewed machine would have a 5-year usable life and would be depreciated
under MACRS using a 5-year recovery period. Renewing the machine would
result in the following projected revenues and expenses (excluding depreciation):
Year
Revenue
Expenses
(excl. depreciation)
1
$1,000,000
$801,500
2
1,175,000
884,200
3
1,300,000
918,100
4
1,425,000
943,100
5
1,550,000
968,100
The renewed machine would result in an increased investment in net working
capital of $15,000. At the end of 5 years, the machine could be sold to net
$8,000 before taxes.
Alternative 2 Replace the existing machine with a new machine that costs
$100,000 and requires installation costs of $10,000. The new machine would
have a 5-year usable life and would be depreciated under MACRS using a 5-
392
PART 3
Long-Term Investment Decisions
year recovery period. The firm’s projected revenues and expenses (excluding
depreciation), if it acquires the machine, would be as follows:
Year
Revenue
Expenses
(excl. depreciation)
1
$1,000,000
$764,500
2
1,175,000
839,800
3
1,300,000
914,900
4
1,425,000
989,900
5
1,550,000
998,900
The new machine would result in an increased investment in net working capital
of $22,000. At the end of 5 years, the new machine could be sold to net $25,000
before taxes.
The firm is subject to a 40% tax on both ordinary income and capital gains.
As noted, the company uses MACRS depreciation. (See Table 3.2 on page 100
for the applicable depreciation percentages.)
Required
a. Calculate the initial investment associated with each of Clark Upholstery’s
alternatives.
b. Calculate the incremental operating cash inflows associated with each of
Clark’s alternatives. (Note: Be sure to consider the depreciation in year 6.)
c. Calculate the terminal cash flow at the end of year 5 associated with each of
Clark’s alternatives.
d. Use your findings in parts a, b, and c to depict on a time line the relevant cash
flows associated with each of Clark Upholstery’s alternatives.
e. Solely on the basis of your comparison of their relevant cash flows, which
alternative appears to be better? Why?
WEB EXERCISE
WW
W
Go to the Web site www.reportgallery.com. Click on Reports, at the top of the
page, navigate to the listing for Intel Corp., and click on Annual Report. This
takes you to an investor relations page; select the most recent annual report.
Answer the following questions using information in various report sections,
such as Intel Facts and Figures, Financial Summary, Consolidated Balance
Sheets, and Consolidated Statements of Cash Flow. (These may change from
year to year and may be listed in the left navigation bar.)
1. How much did Intel spend on capital expenditures for each of the past
5 years?
2. Did capital expenditures increase or decrease?
3. Is Intel’s capital spending consistent or erratic?
CHAPTER 8
Capital Budgeting Cash Flows
393
4. What were the major uses of capital spending for the most recent 2 years?
5. What were the account balances for property, plant, and equipment (PP&E)
for the most recent 2 years (found on the Consolidated Balance Sheets)?
6. What percent of PP&E does Intel replace every year? (Hint: For a rough estimate, divide capital expenditures for a year by that year’s PP&E balance.)
7. Select one of the following companies, and use the Reportgallery site to
access its annual report. Research its capital spending patterns and compare
them to Intel’s.
a. Abbot Laboratories
b. Southwest Airlines
c. Ford Motor Company
Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
CHAPTER
9
CAPITAL
BUDGETING
TECHNIQUES
L E A R N I N G
G O A L S
LG1
Understand the role of capital budgeting techniques in the capital budgeting process.
LG5
LG2
Calculate, interpret, and evaluate the payback
period.
LG6
LG3
Calculate, interpret, and evaluate the net present
value (NPV).
LG4
Calculate, interpret, and evaluate the internal rate
of return (IRR).
Use net present value profiles to compare NPV
and IRR techniques.
Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths
of each approach.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand capital budgeting techniques in order to help determine the after-tax cash flows associated with proposed capital expenditures.
Information systems: You need to understand capital budgeting techniques in order to design decision modules that help
reduce the amount of work required to analyze proposed capital projects.
Management: You need to understand capital budgeting techniques in order to understand the decision criteria used to
accept or reject proposed projects.
394
Marketing: You need to understand capital budgeting
techniques in order to understand how proposals for new marketing programs for new products, and for the expansion of
existing product lines will be evaluated by the firm’s decision
makers.
Operations: You need to understand capital budgeting techniques in order to understand how proposals for the acquisition
of new equipment and plants will be evaluated by the firm’s
decision makers.
DELTA
DELTA CUTS THE WIRES
ave you ever been stuck at an airport
because your flight was late and you
missed your connection? You were frustrated by the long lines at customer service counters and pay phones, and when
you called on your cell phone, you were
placed on hold for what seemed like forever. Wouldn’t it be nice to use your
Internet-capable cell phone or personal digital assistant (PDA) to pull up flight information and
timetables and reschedule your flight? Since 2000, Delta Airlines passengers have been able to
do just that.
The airline was one of the first to recognize that it could increase customer loyalty by giving
business travelers better flight information more quickly. Before Delta’s e-business unit added
this feature, however, the project had to be justified the project on the basis of its economic
value. Unlike making capital budgeting decisions about whether to buy new aircraft or build maintenance facilities, decisions that managers had been making for years, this project was moving
them into uncharted skies—literally.
Delta’s capital budgeting methodology for this Internet project used traditional net present
value (NPV) analysis to develop relevant cash flows, discount them at the company’s cost of capital, and subtract the project’s initial investment. Anticipated cost savings were a major factor in
developing projected cash flows. Wireless Web access enables customers to obtain information
and conduct transactions without calling Delta’s customer service representatives, so the airline
doesn’t have to add employees to handle a larger customer base. Another potential savings: lower
paper costs, because more tickets will be issued electronically, even when last-minute changes
are involved. The system is more cost-effective, thereby resulting in better resource utilization
and a higher ROI.
Improved productivity is another benefit to be derived from this wireless project. Delta
hopes to add self-service features so that passengers can choose seats, check in, and handle
other routine transactions online. This will free reservations agents to handle more calls placed
to purchase tickets, thus generating more revenue. Building on its initial success, Delta is ready
to expand its wireless applications. A joint project with American Airlines, United Airlines, and
Boeing Corporation will equip planes with broadband Internet connections so that the airlines
can sell in-flight wireless services. Delta’s innovative technology initiatives have made it one of
five finalists for Computerworld’s 21st Century Achievement Award.
Delta based its decision to accept the wireless-communication project on the project’s positive NPV, which indicated that the project would earn a return above its cost of capital. This
chapter focuses on the capital budgeting techniques, including NPV, that companies use to
accept or reject and to rank proposed projects.
H
395
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Long-Term Investment Decisions
LG1
9.1 Overview of Capital Budgeting Techniques
When firms have developed relevant cash flows, as demonstrated in Chapter 8,
they analyze them to assess whether a project is acceptable or to rank projects. A
number of techniques are available for performing such analyses. The preferred
approaches integrate time value procedures, risk and return considerations, and
valuation concepts to select capital expenditures that are consistent with the
firm’s goal of maximizing owners’ wealth. This chapter focuses on the use of these
techniques in an environment of certainty. Chapter 10 covers risk and other
refinements in capital budgeting.
We will use one basic problem to illustrate all the techniques described in this
chapter. The problem concerns Bennett Company, a medium-sized metal fabricator that is currently contemplating two projects: Project A requires an initial
investment of $42,000, project B an initial investment of $45,000. The projected
relevant operating cash inflows for the two projects are presented in Table 9.1
and depicted on the time lines in Figure 9.1.1 The projects exhibit conventional
cash flow patterns, which are assumed throughout the text. In addition, we initially assume that all projects’ cash flows have the same level of risk, that projects
being compared have equal usable lives, and that the firm has unlimited funds.
(The risk assumption will be relaxed in Chapter 10.) We begin with a look at the
three most popular capital budgeting techniques: payback period, net present
value, and internal rate of return.2
Hint Remember that the
initial investment is an outflow
occurring at time zero.
TABLE 9.1
Capital Expenditure
Data for Bennett
Company
Initial investment
Year
Project A
Project B
$42,000
$45,000
Operating cash inflows
1
$14,000
$28,000
2
14,000
12,000
3
14,000
10,000
4
14,000
10,000
5
14,000
10,000
1. For simplification, these 5-year-lived projects with 5 years of cash inflows are used throughout this chapter. Projects with usable lives equal to the number of years of cash inflows are also included in the end-of-chapter problems.
Recall from Chapter 8 that under current tax law, MACRS depreciation results in n 1 years of depreciation for an
n-year class asset. This means that projects will commonly have at least 1 year of cash flow beyond their recovery
period. In actual practice, the usable lives of projects (and the associated cash inflows) may differ significantly from
their depreciable lives. Generally, under MACRS, usable lives are longer than depreciable lives.
2. Two other, closely related techniques that are sometimes used to evaluate capital budgeting projects are the average (or accounting) rate of return (ARR) and the profitability index (PI). The ARR is an unsophisticated technique
that is calculated by dividing a project’s average profits after taxes by its average investment. Because it fails to con-
CHAPTER 9
FIGURE 9.1
Capital Budgeting Techniques
397
Project A
Bennett Company’s
projects A and B
Time lines depicting the
conventional cash flows of
projects A and B
$14,000
$14,000
$14,000
$14,000
$14,000
1
2
3
4
5
0
$42,000
End of Year
Project B
$28,000
$12,000
$10,000
$10,000
$10,000
1
2
3
4
5
0
$45,000
End of Year
Review Question
9–1
LG2
Once the firm has determined its projects’ relevant cash flows, what must
it do next? What is its goal in selecting projects?
9.2 Payback Period
payback period
The amount of time required for a
firm to recover its initial investment in a project, as calculated
from cash inflows.
Payback periods are commonly used to evaluate proposed investments. The
payback period is the amount of time required for the firm to recover its initial
investment in a project, as calculated from cash inflows. In the case of an annuity,
the payback period can be found by dividing the initial investment by the annual
sider cash flows and the time value of money, it is ignored here. The PI, sometimes called the benefit–cost ratio, is
calculated by dividing the present value of cash inflows by the initial investment. This technique, which does consider the time value of money, is sometimes used as a starting point in the selection of projects under capital
rationing; the more popular NPV and IRR methods are discussed here.
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PART 3
Long-Term Investment Decisions
cash inflow. For a mixed stream of cash inflows, the yearly cash inflows must be
accumulated until the initial investment is recovered. Although popular, the payback period is generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money.
The Decision Criteria
When the payback period is used to make accept–reject decisions, the decision
criteria are as follows:
• If the payback period is less than the maximum acceptable payback period,
accept the project.
• If the payback period is greater than the maximum acceptable payback
period, reject the project.
The length of the maximum acceptable payback period is determined by management. This value is set subjectively on the basis of a number of factors, including
the type of project (expansion, replacement, renewal), the perceived risk of the
project, and the perceived relationship between the payback period and the share
value. It is simply a value that management feels, on average, will result in valuecreating investment decisions.
EXAMPLE
Hint In all three of the
decision methods presented
in this text, the relevant data
are after-tax cash flows. Accounting profit is used only to
help determine the after-tax
cash flow.
Hint The payback period
indicates to firms taking on
projects of high risk how
quickly they can recover their
investment. In addition, it tells
firms with limited sources of
capital how quickly the funds
invested in a given project will
become available for future
projects.
We can calculate the payback period for Bennett Company’s projects A and B
using the data in Table 9.1. For project A, which is an annuity, the payback
period is 3.0 years ($42,000 initial investment $14,000 annual cash inflow).
Because project B generates a mixed stream of cash inflows, the calculation of its
payback period is not as clear-cut. In year 1, the firm will recover $28,000 of its
$45,000 initial investment. By the end of year 2, $40,000 ($28,000 from year 1 $12,000 from year 2) will have been recovered. At the end of year 3, $50,000 will
have been recovered. Only 50% of the year 3 cash inflow of $10,000 is needed to
complete the payback of the initial $45,000. The payback period for project B is
therefore 2.5 years (2 years 50% of year 3).
If Bennett’s maximum acceptable payback period were 2.75 years, project A
would be rejected and project B would be accepted. If the maximum payback were
2.25 years, both projects would be rejected. If the projects were being ranked, B
would be preferred over A, because it has a shorter payback period.
Pros and Cons of Payback Periods
The payback period is widely used by large firms to evaluate small projects and
by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. It is also appealing in that it considers cash
flows rather than accounting profits. By measuring how quickly the firm recovers
its initial investment, the payback period also gives implicit consideration to the
timing of cash flows and therefore to the time value of money. Because it can be
viewed as a measure of risk exposure, many firms use the payback period as a
decision criterion or as a supplement to other decision techniques. The longer the
firm must wait to recover its invested funds, the greater the possibility of a
calamity. Therefore, the shorter the payback period, the lower the firm’s exposure to such risk.
CHAPTER 9
Capital Budgeting Techniques
399
The major weakness of the payback period is that the appropriate payback
period is merely a subjectively determined number. It cannot be specified in light
of the wealth maximization goal because it is not based on discounting cash flows
to determine whether they add to the firm’s value. Instead, the appropriate payback period is simply the maximum acceptable period of time over which management decides that a project’s cash flows must break even (that is, just equal
the initial investment). A second weakness is that this approach fails to take fully
into account the time factor in the value of money.3 This weakness can be illustrated by an example.
EXAMPLE
DeYarman Enterprises, a small medical appliance manufacturer, is considering
two mutually exclusive projects, which it has named projects Gold and Silver.
The firm uses only the payback period to choose projects. The relevant cash flows
and payback period for each project are given in Table 9.2. Both projects have 3year payback periods, which would suggest that they are equally desirable. But
comparison of the pattern of cash inflows over the first 3 years shows that more
of the $50,000 initial investment in project Silver is recovered sooner than is
recovered for project Gold. For example, in year 1, $40,000 of the $50,000
invested in project Silver is recovered, whereas only $5,000 of the $50,000 investment in project Gold is recovered. Given the time value of money, project Silver
would clearly be preferred over project Gold, in spite of the fact that they both
have identical 3-year payback periods. The payback approach does not fully
account for the time value of money, which, if recognized, would cause project
Silver to be preferred over project Gold.
A third weakness of payback is its failure to recognize cash flows that occur
after the payback period.
TABLE 9.2
Relevant Cash Flows and
Payback Periods for
DeYarman Enterprises’
Projects
Initial investment
Year
Project Gold
Project Silver
$50,000
$50,000
Operating cash inflows
1
$ 5,000
$40,000
2
5,000
2,000
3
40,000
8,000
4
10,000
10,000
5
10,000
10,000
Payback period
3 years
3 years
3. To consider differences in timing explicitly in applying the payback method, the present value payback period is
sometimes used. It is found by first calculating the present value of the cash inflows at the appropriate discount rate
and then finding the payback period by using the present value of the cash inflows.
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FOCUS ON PRACTICE
The high labor component of U.S.
textile manufacturers creates a
cost disadvantage that makes it
hard for them to compete in global
markets. They lag behind other
U.S. industries and foreign textile
producers in terms of plant
automation. One key hurdle is payback period. The industry standard
for capital expenditure projects for
machinery is 3 years. Because few
major automation projects have
such a short payback period, the
EXAMPLE
In Practice
Limits of Payback Analysis
manufacturing effectiveness.
Whereas Japanese managers
will invest $1 million to replace
one job, U.S. managers invest
about $250,000. At prevailing
wage rates, the Japanese
accept a 5- to 6-year payback,
compared to a period of 3 to 4
years in the United States.
These differences underscore
the linkages that exist between
a firm’s operations and finance.
pace of automation has been very
slow. For example, the payback
period for materials transport
automation—moving material from
one point to another with minimum
labor—averages 5 to 6 years.
This situation underscores
a major limitation of payback
period analysis. Companies
that rely only on the payback
period may not give fair consideration to technology that can
greatly improve their long-term
Rashid Company, a software developer, has two investment opportunities, X and
Y. Data for X and Y are given in Table 9.3. The payback period for project X is 2
years; for project Y it is 3 years. Strict adherence to the payback approach suggests that project X is preferable to project Y. However, if we look beyond the
payback period, we see that project X returns only an additional $1,200 ($1,000
in year 3 $100 in year 4 $100 in year 5), whereas project Y returns an additional $7,000 ($4,000 in year 4 $3,000 in year 5). On the basis of this information, project Y appears preferable to X. The payback approach ignored the cash
inflows occurring after the end of the payback period.4
TABLE 9.3
Calculation of the
Payback Period for
Rashid Company’s
Two Alternative
Investment Projects
Initial investment
Year
Project X
Project Y
$10,000
$10,000
Operating cash inflows
1
$5,000
$3,000
2
5,000
4,000
3
1,000
3,000
4
100
4,000
5
100
3,000
2 years
3 years
Payback period
4. To get around this weakness, some analysts add a desired dollar return to the initial investment and then calculate
the payback period for the increased amount. For example, if the analyst wished to pay back the initial investment plus
20% for projects X and Y in Table 9.3, the amount to be recovered would be $12,000 [$10,000 (0.20 $10,000)].
For project X, the payback period would be infinite because the $12,000 would never be recovered; for project Y, the
payback period would be 3.50 years [3 years ($2,000 $4,000) years]. Clearly, project Y would be preferred.
CHAPTER 9
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401
Review Questions
9–2
9–3
LG3
What is the payback period? How is it calculated?
What weaknesses are commonly associated with the use of the payback
period to evaluate a proposed investment?
9.3 Net Present Value (NPV)
net present value (NPV)
A sophisticated capital budgeting technique; found by subtracting a project’s initial investment
from the present value of its cash
inflows discounted at a rate
equal to the firm’s cost of capital.
Because net present value (NPV) gives explicit consideration to the time value of
money, it is considered a sophisticated capital budgeting technique. All such techniques in one way or another discount the firm’s cash flows at a specified rate.
This rate—often called the discount rate, required return, cost of capital, or
opportunity cost—is the minimum return that must be earned on a project to
leave the firm’s market value unchanged. In this chapter, we take this rate as a
“given.” In Chapter 11 we will explore how it is calculated.
The net present value (NPV) is found by subtracting a project’s initial investment (CF0) from the present value of its cash inflows (CFt) discounted at a rate
equal to the firm’s cost of capital (k).
NPV Present value of cash inflows Initial investment
n
CFt
NPV CF0
(1
k)t
t1
(9.1)
n
(CFt PVIFk,t) CF0
(9.1a)
t1
When NPV is used, both inflows and outflows are measured in terms of present
dollars. Because we are dealing only with investments that have conventional
cash flow patterns, the initial investment is automatically stated in terms of
today’s dollars. If it were not, the present value of a project would be found by
subtracting the present value of outflows from the present value of inflows.
The Decision Criteria
When NPV is used to make accept–reject decisions, the decision criteria are as
follows:
• If the NPV is greater than $0, accept the project.
• If the NPV is less than $0, reject the project.
If the NPV is greater than $0, the firm will earn a return greater than its cost of
capital. Such action should enhance the market value of the firm and therefore
the wealth of its owners.
EXAMPLE
We can illustrate the net present value (NPV) approach by using Bennett
Company data presented in Table 9.1. If the firm has a 10% cost of capital, the net
present values for projects A (an annuity) and B (a mixed stream) can be calculated
as shown on the time lines in Figure 9.2. These calculations result in net present
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FIGURE 9.2
Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives
Time lines depicting the cash flows and NPV calculations for projects A and B
Project A
End of Year
0
1
2
3
4
5
$42,000
$14,000
$14,000
$14,000
$14,000
$14,000
k = 10%
53,071
NPVA = $11,071
Project B
0
$45,000
25,455
9,917
7,513
$55,924
6,830
6,209
End of Year
1
$28,000
k = 10%
2
3
4
5
$12,000
$10,000
$10,000
$10,000
k = 10%
k = 10%
k = 10%
k = 10%
NPVB = $10,924
values for projects A and B of $11,071 and $10,924, respectively. Both projects
are acceptable, because the net present value of each is greater than $0. If the projects were being ranked, however, project A would be considered superior to B,
because it has a higher net present value than that of B ($11,071 versus $10,924).
Project A
Input
42000
Function
CF0
14000
CF1
5
N
I
10
NPV
Solution
11071.01
Calculator Use The preprogrammed NPV function in a financial calculator can
be used to simplify the NPV calculation. The keystrokes for project A—the annuity—typically are as shown at left. Note that because project A is an annuity, only
its first cash inflow, CF1 14000, is input, followed by its frequency, N 5.
The keystrokes for project B—the mixed stream—are as shown on page 403.
Because the last three cash inflows for project B are the same (CF3 CF4 CF5 10000), after inputting the first of these cash inflows, CF3, we merely input its
frequency, N 3.
The calculated NPVs for projects A and B of $11,071 and $10,924, respectively, agree with the NPVs cited above.
Spreadsheet Use The NPVs can be calculated as shown on the following Excel
spreadsheet.
CHAPTER 9
Capital Budgeting Techniques
403
Project B
Input
45000
Function
CF0
28000
CF1
12000
CF2
10000
CF3
3
N
10
I
NPV
Solution
10924.40
Review Questions
9–4
9–5
LG4
How is the net present value (NPV) calculated for a project with a conventional cash flow pattern?
What are the acceptance criteria for NPV? How are they related to the
firm’s market value?
9.4 Internal Rate of Return (IRR)
internal rate of return (IRR)
A sophisticated capital
budgeting technique; the
discount rate that equates the
NPV of an investment opportunity
with $0 (because the present
value of cash inflows equals the
initial investment); it is the
compound annual rate of return
that the firm will earn if it invests
in the project and receives the
given cash inflows.
The internal rate of return (IRR) is probably the most widely used sophisticated
capital budgeting technique. However, it is considerably more difficult than NPV
to calculate by hand. The internal rate of return (IRR) is the discount rate that
equates the NPV of an investment opportunity with $0 (because the present value
of cash inflows equals the initial investment). It is the compound annual rate of
return that the firm will earn if it invests in the project and receives the given cash
inflows. Mathematically, the IRR is the value of k in Equation 9.1 that causes
NPV to equal $0.
n
t
$0 t CF0
t1
CF
(1 IRR)
(9.2)
n
CFt
CF0
(1
IRR)t
t1
(9.2a)
The Decision Criteria
When IRR is used to make accept–reject decisions, the decision criteria are as
follows:
• If the IRR is greater than the cost of capital, accept the project.
• If the IRR is less than the cost of capital, reject the project.
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Long-Term Investment Decisions
These criteria guarantee that the firm earns at least its required return. Such an
outcome should enhance the market value of the firm and therefore the wealth of
its owners.
Calculating the IRR
WW
W
FIGURE 9.3
The actual calculation by hand of the IRR from Equation 9.2a is no easy chore.
It involves a complex trial-and-error technique that is described and demonstrated on this text’s Web site: www.aw.com/gitman. Fortunately, many financial calculators have a preprogrammed IRR function that can be used to simplify the IRR calculation. With these calculators, you merely punch in all cash
flows just as if to calculate NPV and then depress IRR to find the internal rate
of return. Computer software, including spreadsheets, is also available for simplifying these calculations. All NPV and IRR values presented in this and subsequent chapters are obtained by using these functions on a popular financial
calculator.
Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives
Time lines depicting the cash flows and IRR calculations for projects A and B
Project A
End of Year
0
1
2
$42,000
$14,000
$14,000
0
1
$45,000
5
$14,000
$14,000
$14,000
3
4
5
$10,000
$10,000
$10,000
IRRA = 19.9%
Project B
0
4
IRR?
42,000
NPVA = $
3
$28,000
IRR?
2
End of Year
$12,000
IRR?
45,000
IRR?
IRR?
IRR?
NPVB = $
0
IRRB = 21.7%
CHAPTER 9
EXAMPLE
Capital Budgeting Techniques
405
We can demonstrate the internal rate of return (IRR) approach using Bennett
Company data presented in Table 9.1. Figure 9.3 (page 404) uses time lines to
depict the framework for finding the IRRs for Bennett’s projects A and B, both of
which have conventional cash flow patterns. It can be seen in the figure that the
IRR is the unknown discount rate that causes the NPV just to equal $0.
Calculator Use To find the IRR using the preprogrammed function in a financial calculator, the keystrokes for each project are the same as those shown on
page 403 for the NPV calculation, except that the last two NPV keystrokes
(punching I and then NPV) are replaced by a single IRR keystroke.
Comparing the IRRs of projects A and B given in Figure 9.3 to Bennett
Company’s 10% cost of capital, we can see that both projects are acceptable
because
IRRA 19.9% 10.0% cost of capital
IRRB 21.7% 10.0% cost of capital
Comparing the two projects’ IRRs, we would prefer project B over project A
because IRRB 21.7% IRRA 19.9%. If these projects are mutually exclusive,
the IRR decision technique would recommend project B.
Spreadsheet Use The internal rate of return also can be calculated as shown
on the Excel spreadsheet on page 405.
It is interesting to note in the preceding example that the IRR suggests that
project B, which has an IRR of 21.7%, is preferable to project A, which has an
IRR of 19.9%. This conflicts with the NPV rankings obtained in an earlier
example. Such conflicts are not unusual. There is no guarantee that NPV and
IRR will rank projects in the same order. However, both methods should reach
the same conclusion about the acceptability or nonacceptability of projects.
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FOCUS ON PRACTICE
In Practice
EVAlue Creation
Answering the question “Does the
company use investors’ money
wisely?” is one of the financial
manager’s chief responsibilities
and greatest challenges. At many
firms—from Fortune 500 companies and investment firms to community hospitals—economic value
added (EVA®) is the measurement
tool of choice for making investment decisions, measuring overall
financial performance, and motivating management.
Developed in 1983 by financial consultants Stern Stewart and
protected by trademark, EVA® is
the difference between an investment’s net operating profits after
taxes and the cost of funds used to
finance the investment (the
amount of capital times the company’s cost of capital). An investment with a positive EVA®
exceeds the firm’s cost of capital
and therefore creates wealth. The
EVA® calculation is similar to calculating internal rate of return
(IRR), except that the result is
stated in dollars rather than percentages. It can be applied to the
company as a whole as well as to
specific long-term investments
such as new facilities or equipment and acquisitions.
According to its proponents,
EVA® represents “real” profits and
provides a more accurate measure than accounting profits. Over
time, it also has better correlation
with stock prices than does earnings per share (EPS). Income calculations include only the cost of
debt (interest expense), whereas
EVA® uses the total cost of capital—both debt and equity (an
expensive form of capital). In addition, EVA® treats research and
development (R&D) outlays as
investments in future products or
processes and capitalizes rather
than expenses them. A growing
EVA® can signal future increases
in stock prices.
Companies that use EVA®
believe doing so leads to better
overall performance. Managers
who apply it focus on allocating
and managing assets, not just
accounting profits. They will
accelerate the development of a
hot new product even if it reduces
earnings in the near term. Likewise, EVA®-driven companies will
expense rather than capitalize the
cost of a new venture. Although
earnings will drop for a few quarters, so will taxes—and cash flow
actually increases.
EVA® is not a panacea, however. Its critics say it’s just another
accounting measure and may not
be the right one for many companies. They claim that because it
favors big projects in big companies, it doesn’t do a good job on
capital allocation.
Each year Fortune and Stern
Stewart publish a “wealth creators” list that answers a critical
question: Is the company creating
or destroying wealth for its shareholders? This list uses both EVA®
and market value added (MVA®)—
the difference between what
investors can now take out of a
company and what they put in—to
rank companies. In 2001 the list
also included another measure,
future growth value, an estimate of
the value of the companies’ future
growth today, based on current net
operating profits after taxes.
General Electric again topped the
2001 list, followed by Microsoft,
Wal-Mart, IBM, and Pfizer.
EVA® is gaining acceptance
worldwide as well. At the French
corporation Danone, chief executive Franck Riboud uses an EVA®
formula to measure performance.
“It’s a question of tools and language,” says Riboud. “If I talk
EVA®, I will be understood all over
the world.”
Sources: Geoffrey Colvin, “Earnings Aren’t
Everything,” Fortune (September 17, 2001),
p. 58; Janet Guyon, “Companies Around
the World Are Going the America Way,”
Fortune (November 26, 2001), pp. 114–120;
Randy Myers, “Measure for Measure,” CFO
(November 1997), downloaded from www.
cfonet.com; Stern Stewart Web site, www.
sternstewart.com; and David Stires,“
America’s Best and Worst Wealth Creators,”
Fortune (December 10, 2001), pp. 137–142.
Review Questions
9–6
9–7
9–8
What is the internal rate of return (IRR) on an investment? How is it
determined?
What are the acceptance criteria for IRR? How are they related to the
firm’s market value?
Do the net present value (NPV) and internal rate of return (IRR) always
agree with respect to accept–reject decisions? With respect to ranking decisions? Explain.
CHAPTER 9
LG5
LG6
Capital Budgeting Techniques
407
9.5 Comparing NPV and IRR Techniques
To understand the differences between the NPV and IRR techniques and decision
makers’ preferences in their use, we need to look at net present value profiles,
conflicting rankings, and the question of which approach is better.
Net Present Value Profiles
net present value profile
Graph that depicts a project’s
NPVs for various discount rates.
EXAMPLE
Projects can be compared graphically by constructing net present value profiles that
depict the projects’ NPVs for various discount rates. These profiles are useful in
evaluating and comparing projects, especially when conflicting rankings exist. They
are best demonstrated via an example.
To prepare net present value pro